1. To Accompany “Economics: Private and Public Choice 10th ed.” James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson Slides authored and animated by: James Gwartney, David Macpherson, & Charles Skipton Full Length Text — Macro Only Text — Part: Chapter: Next page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy 312 3

2. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Budget Deficits & Surpluses

3. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Budget Deficits and Surpluses Budget deficit: Present when total government spending exceeds total revenue from all sources. When the money supply is constant, deficits must be covered with borrowing. The U.S. Treasury borrows by issuing bonds. Budget surplus: Present when total government spending is than total revenue. Surpluses reduce the magnitude of the government’s outstanding debt.

4. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Budget Deficits and Surpluses Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is stimulating or restraining demand. Changes in the size of the budget deficit or surplus may arise from either: A change in the state of the economy, or, A change in discretionary fiscal policy. The federal budget is the primary tool of fiscal policy. Discretionary changes in fiscal policy: deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.

5. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Keynesian View of Fiscal Policy

6. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Keynesian View of Fiscal Policy Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in demand. When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy, by: increasing the government’s purchases of goods & services, and/or, cutting taxes.

7. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 1 At e 1 (Y 1 ), the economy is below it’s potential capacity Y F. There are 2 routes to long-run full-employment equilibrium: Expansionary Fiscal Policy Price Level LRAS Y F Y1Y1 P2P2 AD 2 Goods & Services (real GDP) Expansionary fiscal policy stimulates demand and directs the economy to full-employment SRAS 1 P1P1 Wait for lower wages and resource prices to reduce costs, increase supply to SRAS 2 and restore equilibrium to E 3, at Y F. SRAS 2 P3P3 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. e1e1 E2E2 Alternatively, expansionary fiscal policy could stimulate AD (shift to AD 2 ) and guide the economy back to E 2, at Y F. E3E3

8. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Keynesian View of Fiscal Policy When inflation is a potential problem, the Keynesian analysis suggests a shift toward a more restrictive fiscal policy: reduce government spending, and/or, raise taxes. Keynesians challenged the view that governments should always balance their budget. Rather than balancing the budget annually, Keynesians argue that counter-cyclical policy should be used to offset fluctuations in aggregate demand.

9. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 1 Strong demand such as AD 1 will temporarily lead to an output rate beyond the economy’s long-run potential Y F. Restrictive Fiscal Policy Price Level LRAS Y F Y1Y1 P3P3 AD 2 Goods & Services (real GDP) Restrictive fiscal policy restrains demand and helps control inflation. SRAS 2 P1P1 If maintained, the strong demand will lead to the long-run equilibrium E 3 at a higher price level (SRAS shifts to SRAS 2 ). SRAS 1 P2P2 E3E3 Restrictive fiscal policy could reduce demand to AD 2 (or keep AD from shifting to AD 1 initially) and lead to equilibrium E 2. e1e1 E2E2

10. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy and the Crowding-out Effect

11. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Crowding-out Effect The Crowding-out effect – indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy. The implications of the crowding-out analysis are symmetrical. Restrictive fiscal policy will reduce real interest rates and "crowd in" private spending. Crowding-out effect in an open economy: Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

12. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Increase in budget deficit Higher real interest rates Inflow of financial capital from abroad Decline in private investment Appreciation of the dollar Decline in net exports Crowding-Out in an Open Economy An increase in government borrowing to finance an enlarged budget deficit, places upward pressure on real interest rates. This retards private investment and Aggregate Demand. In an open economy, high interest rates attract foreign capital. As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. The appreciation of the dollar causes net exports to fall. Thus, the larger deficits and higher interest rates trigger reductions in both private investment and net exports, which limit the expansionary impact of a budget deficit.

13. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The New Classical View of Fiscal Policy

14. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The New Classical View of Fiscal Policy The New Classical view stresses that: debt financing merely substitutes higher future taxes for lower current taxes, and thus, budget deficits affect the timing of taxes, but not their magnitude. New Classical economists argue that when debt is substituted for taxes: people save the increased income so they will be able to pay the higher future taxes, thus, the budget deficit does not stimulate aggregate demand.

15. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The New Classical View of Fiscal Policy Similarly, New Classical economists believe that the real interest rate is unaffected by deficits as people save more in order to pay the higher future taxes. Further, they believe fiscal policy is completely impotent – that it does not effect output, employment, or real interest rates.

16. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 1 New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes. Expansionary Fiscal Policy Price Level Y1Y1 Goods & Services (real GDP) SRAS 1 P1P1 If households did not anticipate the higher future taxes, aggregate demand would increase (from AD 1 to AD 2 ). However, when households fully anticipate the future taxes and save for them, demand remains unchanged at AD 1. AD 2

17. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Quantity of loanable funds Q1Q1 S1S1 Q2Q2 Loanable Funds Market Real interest rate r 1 S2S2 D 2 To finance the budget deficit, the government borrows from the loanable funds market, increasing the demand (to D 2 ). With the new classical view, people save to pay expected higher future taxes (raising the supply of loanable funds to S 2.) This permits the government to borrow the funds to finance the deficit without pushing up the interest rate. Expansionary Fiscal Policy D 1 Here, fiscal policy exerts no effect on the interest rate, real GDP, and unemployment. e1e1 e2e2

18. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 1.“When the federal government runs a budget deficit, it finances the deficit by issuing additional U.S. Treasury bonds.” -- Is this statement true? 2. When an economy is operating below its potential capacity, Keynesian economists argue that a.taxes should be raised if the government is currently running a budget deficit. b.the government should cut taxes and/or increase expenditures in order to stimulate aggregate demand. c.government spending should be cut and the budget shifted toward a surplus.

19. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 3.The crowding out effect indicates that budget deficits a.will stimulate aggregate demand and so exert a strong impact on both output & employment. b.will lead to additional borrowing and higher interest rates that will reduce the level of private spending. 4.“New classical economists stress that an increase in government expenditures financed by borrowing rather than taxes will lead to higher interest rates.” -- Is this statement true?

20. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy: Problems of Proper Timing

21. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Problems with Proper Timing Time lags make proper timing of changes in discretionary fiscal policy difficult. Discretionary fiscal policy is like a two-edged sword; it can both harm and help: If timed correctly, it may reduce economic instability. If timed incorrectly, however, it may increase economic instability.

22. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 0 Consider a market at long-run equilibrium E 0 where only the natural rate of unemployment is present. Timing of Fiscal Policy is Difficult Price Level LRAS Y0Y0 Y1Y1 AD 1 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 E0E0 e1e1 An investment slump and business pessimism result in an unanticipated decline in AD (to AD 1 ). Output falls (to Y 1 ) and unemployment increases.

23. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 1 AD 0 After a time, policymakers consider expansionary fiscal policy seeking to shift AD 1 back to AD 0. But as unanticipated aggregate demand shocks are both difficult to forecast and equally difficult to confirm, it takes some time to construct and implement the fiscal policy. Timing of Fiscal Policy is Difficult Price Level LRAS Y0Y0 Y1Y1 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 E0E0 e1e1 Suppose that shifts in AD are difficult to forecast.

24. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 0 By the time fiscal policy begins to exert its primary effect, private investment has recovered and decision makers have become increasingly optimistic about the future. Price Level LRAS Y0Y0 Y1Y1 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 Thus, just as AD begins shifting back to AD 0 by its own means, the effects of fiscal policy over-shift AD to AD 2. AD 1 Timing of Fiscal Policy is Difficult

25. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 1 AD 0 The price level in the economy rises (from P 1 to P 2 ) as the economy is now overheating. Price Level LRAS Y 0 Y1Y1 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 e2e2 Y2Y2 Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS 2 (driving the price level up to P 3 ). P3P3 SRAS 2 Timing of Fiscal Policy is Difficult E3E3

26. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 0 Alternatively, suppose an investment boom disrupts the initial equilibrium shifting AD out to AD 2, and prices upward to P 2. Price Level LRAS Y0Y0 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 E0E0 Y2Y2 Policymakers respond by considering an increase in taxes and cut in government expenditures; but, it takes time to recognize the unexpected expansion and construct the policy. Timing of Fiscal Policy is Difficult AD 2 e2e2

27. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. By the time that the restrictive fiscal policy has had an opportunity to take effect, investment returns to its normal rate (shifting AD 2 back to AD 0 ). Price Level LRAS Y0Y0 Goods & Services (real GDP) P0P0 SRAS 1 AD 2 Thus, just as AD begins shifting back to AD 0 by its own means, the effects of fiscal policy over-shift AD to AD 1. Timing of Fiscal Policy is Difficult P2P2 e2e2 Y2Y2 AD 1 Suppose that shifts in AD are difficult to forecast. E0E0 AD 0

28. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 1 AD 0 The price level in the economy falls (from P 2 to P 1 ) as the economy is thrown into a recession. Price Level LRAS Y0Y0 Y1Y1 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 e2e2 Y2Y2 Because fiscal policy does not work instantaneously, and since dynamic factors are constantly influencing private demand, proper timing of fiscal policy is not an easy task. Timing of Fiscal Policy is Difficult

29. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Problems with Proper Timing Automatic Stabilizers: without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. Examples of automatic stabilizers: Unemployment compensation Corporate profit tax A progressive income tax

30. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy as a Stabilization Tool: A Modern Synthesis

31. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy: A Modern Synthesis The proper timing of discretionary fiscal policy is both difficult to achieve and of crucial importance. Automatic stabilizers reduce the fluctuation of aggregate demand and help to direct the economy toward full-employment. Fiscal policy is much less potent than the early Keynesian view implied.

32. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 1. Why is the proper timing of changes in fiscal policy so important? Why is it difficult to achieve? 2.Which of the following will make it more difficult to institute discretionary changes in fiscal policy in a manner that will exert a stabilizing impact on the economy? a.The lengthy time period required for passage of a fiscal policy change under a political system with substantial checks and balances. b.Improvements in forecasting devices that provide information about the future direction of the economy.

33. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 3.“Legislative action is necessary if automatic stabilizers are going to smooth the ups and downs of the business cycle.” -- Is this statement true? 4.“Both the crowding out and new classical views indicate fiscal policy is substantially less potent than the Keynesian view implies.” -- Is this statement true?

34. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Supply-side Effects of Fiscal Policy

35. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Supply-side Effects of Fiscal Policy From a supply-side viewpoint, the marginal tax rate is of crucial importance: A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less heavily taxed. High marginal tax rates will tend to retard total output because they will: Discourage work effort and reduce the productive efficiency of labor, Adversely affect the rate of capital formation and the efficiency of its use, and, Encourage individuals to substitute less desired tax-deductible goods for more desired non-deductible goods.

36. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Supply-side Effects of Fiscal Policy So, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance. Impact of supply-side effects: Usually take place over a lengthy time period. There is some evidence that countries with high taxes grow more slowly—France and Germany versus United Kingdom. While the significance of supply-side effects are controversial, there is evidence they are important for taxpayers facing extremely high tax rates – say rates of 40 percent and above.

37. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD 1 What are the supply-side effects of a drop in marginal tax rates? Supply Side Economics and Tax Rates Price Level LRAS 1 Y F2 Y F1 AD 2 Goods & Services (real GDP) With time, lower tax rates promote more rapid growth (shifting LRAS and SRAS out to LRAS 2 and SRAS 2 ). SRAS 1 P 0 SRAS 2 E1E1 LRAS 2 E2E2 Lower marginal tax rates increase the incentive to earn and use resources efficiently. AD 1 shifts out to AD 2, and SRAS & LRAS shift to the right. If the tax cuts are financed by budget deficits, AD may expand by more than supply, bringing an increase in the price level.

38. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. 22 % 21 % 20 % 19 % 18 % 17 % 16 % 1960 15 % 14 % Share of income taxes paid by top ½ % of earners Share of Taxes Paid By the Rich 1995199019801975197019651985 1998 1964-65 Top rate cut from 91% to 70% 1981 Top rate cut from 70% to 50% 1990-93 Top rate raised from 30% to 39% 1986 Top rate cut from 50% to 30% 1997 Capital gains tax rate cut The share of the personal income tax paid by the top one-half percent of earners is shown here. During the last four decades, the share of taxes paid by these earners has increased as the top tax rates have declined. This indicates that the supply side effects are strong for these taxpayers.

39. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy of the United States

40. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. U.S. Fiscal Policy, 1960-2001 During the 1960s & 70s, budget deficits were generally small except during recessions. Budget deficits generally increased during recessions and shrank during expansions, primarily as the result of automatic stabilizers rather than discretionary policy changes. Reductions in income tax rates and sharp increases in defense expenditures led to large deficits during the 1980s. The deficit shrank during the 1990s and surpluses were present by the end of the decade.

41. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. U.S. Fiscal Policy, 1960-2001 Even though the federal deficits were large during the 1980s and small during the 1990s, real economic growth was strong and the inflation rate low during both decades.

42. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Transforming the Deficits of the 1980s to Surpluses in the 1990s Three major factors shifted the federal budget toward a surplus during the 1990s: Strong Expansion: As income grew steadily during the ‘90s, more of it was taxed at higher rates. Thus, tax revenues increased as a share of the economy. Cuts in Defense Spending: After the Cold War, defense spending fell and slowed the growth of federal spending. Favorable Demographics: Baby boomers moved into their prime-earning years, boosting tax revenues, while the slow growth of the elderly population helped to control Social Security & Medicare spending.

43. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Federal Expenditures and Revenues The federal deficit or surplus as a share of the economy is shown here. Note the growth of budget deficits during the 1980s and the movement to surpluses during the 1990s. 18 20 22 24 196019651970197519801985199019952000 Expenditures Revenues Expenditures Federal Government Expenditures and Revenues (as a share of GDP) Source: Economic Report of the President, 2001. Note, recessions are indicated by shaded bars.

44. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Growth of Real Federal Government and Defense Expenditures During the 1980s, rapid growth of defense spending pushed federal spending upward and contributed substantially to the large deficits of the decade. During the 1990s, defense cuts retarded the growth of federal spending and thereby helped shift the budget to surplus. Defense Total 8 % 6 % 4 % 2 % 0 % - 2 % - 4 % Percent rate of change 19801985199019952000

45. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy: Current View and Future Direction Both political considerations and secondary effects implied by the crowding-out and new classical theories reduce the potential of fiscal policy as a stabilization tool. Both the recession of 2001 and increased spending on national defense and domestic security shifted the budget from surplus to deficit during 2001-2002.

46. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Fiscal Policy: Current View and Future Direction Political and demographic factors are likely to drive fiscal policy in the future. A re-emergence of large deficits seems likely for two reasons: Public choice analysis indicates that vote- maximizing politicians have a strong incentive to both increase spending and keep taxes low. Once the baby boomers begin to retire around 2010, it will be extremely difficult to control the growth of spending on two large programs: Social Security and Medicare.

47. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 1.How does the supply-side view of fiscal policy differ from the demand-side view? Does the supply-side view stress the potential of fiscal policy as a tool to smooth the ups and downs of business cycles? What does it stress? 2.“The share of personal income taxes collected from high income taxpayers has steadily declined during the last 20 years.” -- Is this statement true? 3.“Public choice theory indicates that vote- maximizing politicians severely restrains govt. spending because they have a strong incentive to achieve and maintain budget surpluses.” -- Is this statement true?

48. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 5.“Under a progressive tax system, as incomes grow, taxes will take a larger and larger share of income unless legislative action is taken.” -- Is this statement true? 4. The following is from the mid-1980s by Paul Samuelson, a leading American Keynesian: “In the early stages of the Keynesian revolution, macro-economists emphasized fiscal policy as the most powerful and balanced remedy for demand management. Gradually, shortcomings of fiscal policy became apparent. The short- comings stem from timing, politics, macro- economic theory, and the deficit itself." Explain what Samuelson means by each of the shortcomings he refers to?

49. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. End Chapter 12