3. Fiscal Policy FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU
The conventional wisdom among both politicians and economic policymakers for years was that active use by the government of changes in spending and taxes could play only a limited role in fighting recessions.
Economics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.
P R E P A R E D B Y
FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU

4. A P P L Y I N G T H E C O N C E P T S
Why are the United States and many other countries facing dramatically increasing costs for their government programs?
Increasing Life Expectancy and Aging Populations Spur Costs of Entitlement Programs
How are tax rates and tax revenues related?
The Confucius Curve?
Did the 2001 tax cuts stimulate consumer spending?
Were the 2001 Tax Cuts Spent or Saved? 1 2 3

5. Fiscal Policy
● fiscal policy Changes in government taxes and spending that affect the level of GDP.

6. THE ROLE OF FISCAL POLICY
10.1
THE ROLE OF FISCAL POLICY
Fiscal Policy and Aggregate Demand
FIGURE 10.1 Fiscal Policy in Action
Panel A shows that an increase in government spending shifts the aggregate demand curve from AD0 to AD1, restoring the economy to full employment. This is an example of expansionary policy.
Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD0 to AD1, restoring the economy to full employment. This is an example of contractionary policy.

7. THE ROLE OF FISCAL POLICY
10.1
THE ROLE OF FISCAL POLICY
Fiscal Policy and Aggregate Demand
● expansionary policies Government policy actions that lead to increases in aggregate demand.
● contractionary policies Government policy actions that lead to decreases in aggregate demand.

8. THE ROLE OF FISCAL POLICY
10.1
THE ROLE OF FISCAL POLICY
The Fiscal Multiplier
As the government develops policies to stabilize the economy, it needs to take the multiplier into account. The total shift in aggregate demand will be larger than the initial shift. As we will see later in this chapter, U.S. policymakers have taken the multiplier into account as they have developed policies for the economy.
The Limits to Stabilization Policy
● stabilization policies Policy actions taken to move the economy closer to full employment or potential output.

9. THE ROLE OF FISCAL POLICY
10.1
THE ROLE OF FISCAL POLICY
The Limits to Stabilization Policy
LAGS
FIGURE 10.2 Possible Pitfalls in Stabilization Policy
Panel A shows an example of successful stabilization policy. The solid line represents the behavior of GDP in the absence of policies.
The dashed line shows the behavior of GDP when policies are in place. Successfully timed policies help smooth out economic fluctuations.
Panel B shows the consequences of ill-timed policies. Again, the solid line shows GDP in the absence of policies and the dashed line shows GDP with policies in place. Notice how ill-timed policies make economic fluctuations greater.

10. THE ROLE OF FISCAL POLICY
10.1
THE ROLE OF FISCAL POLICY
The Limits to Stabilization Policy
LAGS
● inside lags The time it takes to formulate a policy.
● outside lags The time it takes for the policy to actually work.
FORECASTING UNCERTAINTIES
What makes the problem of lags even worse is that economists are not very accurate in forecasting what will happen in the economy.

11. 10.2
THE FEDERAL BUDGET
Federal Spending

12. 10.2 THE FEDERAL BUDGET Federal Spending
● discretionary spending The spending programs that Congress authorizes on an annual basis.
● entitlement and mandatory spending Spending that Congress has authorized by prior law, primarily providing support for individuals.

13. 10.2 THE FEDERAL BUDGET Federal Spending
● Social Security A federal government program to provide retirement support and a host of other benefits.
● Medicare A federal government health program for the elderly.
● Medicaid A federal and state government health program for the poor.

14. A P P L I C A T I O N 1
INCREASING LIFE EXPECTANCY AND AGING POPULATIONS
SPUR COSTS OF ENTITLEMENT PROGRAMS
APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing costs for their government programs?
Today, Social Security, Medicare, and Medicaid constitute approximately 9 percent of GDP.
Experts estimate that in 2075 spending on these programs will be approximately 21 percent of GDP.
How will our society cope with increased demands for these services?
Possible solutions:
Leave the existing programs in place and just raise taxes to pay for them.
The government should save and invest now to increase GDP in the future to reduce the burden on future generations.
Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being.
Reform the health-care system to encourage more competition to reduce health-care expenditures.

15. 10.2
THE FEDERAL BUDGET
Federal Revenues

16. 10.2 THE FEDERAL BUDGET Federal Revenues
SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE
● supply-side economics A school of thought that emphasizes the role that taxes play in the supply of output in the economy.
● Laffer curve A relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged.

17. A P P L I C A T I O N 2
THE CONFUCIUS CURVE?
APPLYING THE CONCEPTS #2: How are tax rates and tax revenues related?
While the idea that cutting tax rates might actually increase tax revenue is often attributed to economist Arthur Laffer, in fact, it is actually a much older idea than that.
Yu Juo, one of the twelve wise men who succeeded Confucius in ancient China, was asked what should be done in the case of a famine if the government had insufficient funds. He replied that the tax rate should be cut to 10 percent. Skeptical government bureaucrats did not have enough funds at a 20 percent rate, so how could they cut it to 10 percent?
Yu Juo replied, “Cutting taxes and limiting your expenses allow people to raise their standard of living. Afterwards, you will no longer need to worry about famine and shortage.”
Revenue estimators in Washington, D.C, do not share entirely in Yu Juo’s wisdom, but they do recognize that cutting tax rates will stimulate economic activity.

18. 10.2 THE FEDERAL BUDGET The Federal Deficit and Fiscal Policy
● budget deficit The amount by which government spending exceeds revenues in a given year.
● budget surplus The amount by which government revenues exceed government expenditures in a given year.

19. 10.2 THE FEDERAL BUDGET Automatic Stabilizers
The increased federal budget deficit works through three channels:
1 Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income.
2 Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much.
3 Because the corporation tax depends on corporate profits and profits fall in a recession, taxes on businesses also fall. Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession.
● automatic stabilizers Taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action.

20. 10.2
THE FEDERAL BUDGET
Are Deficits Bad?

21. FISCAL POLICY IN U.S. HISTORY
10.3
FISCAL POLICY IN U.S. HISTORY
The Depression Era
During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits. According to Brown, fiscal policy was expansionary only during two years of the Great Depression, 1931 and 1936.
The Kennedy Administration
Although modern fiscal policy was not deliberately used during the 1930s, the growth in military spending at the onset of World War II in 1941 increased total demand in the economy and helped pull the economy out of its long decade of poor performance. But to see fiscal policy in action, we need to turn to the 1960s. It was not until the presidency of John F. Kennedy during the early 1960s that modern fiscal policy came to be accepted.

22. FISCAL POLICY IN U.S. HISTORY
10.3
FISCAL POLICY IN U.S. HISTORY
The Vietnam War Era
● permanent income An estimate of a household’s long-run average level of income.
The Reagan Administration
The tax cuts enacted during 1981 at the beginning of the first term of President Ronald Reagan were significant. However, they were not proposed to increase aggregate demand. Instead, the tax cuts were justified on the basis of improving economic incentives and increasing the supply of output.

23. FISCAL POLICY IN U.S. HISTORY
10.3
FISCAL POLICY IN U.S. HISTORY
The Clinton and George W. Bush Administrations
 FIGURE 10.3 Federal Taxes, Spending, and Deficits, 1996–2006

24. A P P L I C A T I O N 3
WERE THE 2001 TAX CUTS SPENT OR SAVED?
APPLYING THE CONCEPTS #3: Did the 2001 tax cuts stimulate consumer spending?
In 2001, approximately 90 million U.S. households received tax rebate checks from the government.
According to conventional economic theory, a permanent cut in taxes should largely be spent by households because it represents a new permanent source of income for them.
To discover whether households actually spent the tax cuts, professors Matthew Shapiro and Joel Slemrod decided to ask some of them.
Result: Fewer than 25 percent of households were likely to spend the rebate. Moreover, low-income households were no more likely to spend the rebate than higher-income households.
These survey results may not reflect the actual behavior of consumers. The Congressional Budget Office reviewed other studies that directly examined consumer spending after the rebates.
Result: Financially strapped households do spend any tax cuts they receive.

25. K E Y T E R M S automatic stabilizers budget deficit budget surplus
contractionary policies
discretionary spending
entitlement and mandatory spending
expansionary policies
fiscal policy
inside lags
Laffer curve
Medicaid
Medicare
outside lags
permanent income
Social Security
stabilization policies
supply-side economics