1. 11
FISCAL POLICY
CHAPTER

2. Objectives After studying this chapter, you will able to
Describe the federal budget process
Describe the recent history of federal expenditures, tax revenues, and the budget deficit
Distinguish between automatic and discretionary fiscal policy
Define and explain the fiscal policy multipliers
Explain the effects of fiscal policy in both the short run and the long run
Distinguish between and explain the demand-side and supply-side effects of fiscal policy

3. Balancing Acts on Capitol Hill
In 2003, the federal government planned to spend 18 cents out of each dollar earned in the United States, and collect nearly as much in taxes.
How does that affect the economy?
For most of the 1980s and 1990s, the government ran deficits, to the extent that the national debt is now about $12,000 per person.
What are its effects, and how can deficits be avoided?

4. The Federal Budget
The federal budget is the annual statement of the federal government’s expenditures and tax revenues.
Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained long-term economic growth, and price level stability.

5. The Federal Budget The Institutions and Laws
Fiscal policy is made by the president and Congress.
Figure 11.1 illustrates the timeline.

6. The Federal Budget
Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work toward “maximum employment, production, and purchasing power.”
The President’s Council of Economic Advisers monitors the economy and advises the President on economic policy.

7. The Federal Budget Highlights of the 2003 Budget
The projected fiscal 2003 Federal Budget has tax revenues of $2,080 billion, expenditures of $2,158 billion, and a projected deficit of $78 billion.
Tax revenues come from personal income taxes, social insurance taxes, corporate income taxes, and indirect taxes.
Personal income taxes followed by social insurance taxes are the two largest revenue sources.

8. The Federal Budget
Expenditures are classified as transfer payments, purchases of goods and services, and debt interest.
Transfer payments are by far the largest expenditure, and are sources of persistent growth in expenditures.

9. The Federal Budget
The federal government’s budget balance equals tax revenue minus expenditure.
If tax revenues exceed expenditures, the government has a budget surplus.
If expenditures exceed tax revenues, the government has a budget deficit.
If tax revenues equal expenditures, the government has a balanced budget.

10. The Federal Budget The Budget in Historical Perspective
Figure 11.2 on the next slide shows the government’s tax revenues, expenditures, and budget surplus or deficit as a percentage of GDP for the period 1983–2003.
The government had a deficit of 5.2 percent in 1983.
The deficit declined and in 1998 to 2001, the government had a surplus.
A deficit arose again in 2002 and 2003.

11. The Federal Budget

12. The Federal Budget
Figure 11.3 on the next slide shows the evolution of the components of tax revenues and expenditures as a percentage of GDP over the period 1983–2003.
Tax revenues increased and expenditures decreased.

13. The Federal Budget

14. The Federal Budget
Government debt is the total amount that the government has borrowed—that the government owes. It is the accumulation of all past deficits.
Deficit and debt. Many students need help with the distinction between the deficit and the debt (and with what happens to the debt when there is a surplus). Use the student loan or credit card analogy. Explain that the budget balance—the deficit or surplus—is just like a personal budget balance—the amount that a student borrows or pays back during a given year. The debt—the amount owed by the government—is like the balance on a student loan or credit card account. Students (usually) have a budget deficit and increasing debt. And graduates with a job (usually) have a budget surplus and decreasing debt.
An interesting historical episode. During the mid-1830s—a long time ago—the U.S. government had virtually repaid all its debt. At that time the government faced a problem that doesn’t occur today: it had a surplus and didn’t know what to do with it. The decision was made to transfer money to the state governments. Each state was to receive $400,000 in four payments of $100,000 each. The first three payments were made, but the last one was postponed because of a recession in 1837 that lowered the federal government’s revenue and then was never made. In the 1970s, faced with a severe budget crunch, the State of New York sued to receive that last payment plus interest. The state lost the suit and so the last payment probably will never be made! (You might remark that $100,000 invested in 1837 at the average interest rate would have accumulated to about $23 billion by 2002!)
Does the debt matter? You can have endless fun debating this question. If you do engage your students in this question, you will want to point them to thinking about:
1. The distinction between domestically held debt and foreign held debt.
2. No matter how much the government owes (or has invested in trust funds such as those for Social Security and Medicaid), every single year, Y = C + I + G + X – M, so the resources available depend on productive capacity, not on paper claims.

15. The Federal Budget
Figure 11.4 shows the evolution of the debt as a percentage of GDP since 1942.

16. The Federal Budget The U.S. Government Budget in Global Perspective
Figure 11.5 compares government budget deficits around the world in 2001.
The world as a whole that year had a government budget deficit of about 1.5 percent of world GDP.

17. The Federal Budget State and Local Budgets
In 2001, when the federal government spent $1,900 billion, state and local governments spent about $1,300 billion, mostly on education, protective services, and roads.
State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.

18. Fiscal Policy Multipliers
Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.
Discretionary fiscal policy is a policy action that is initiated by an act of Congress.
To enable us to focus on the principles of fiscal policy multipliers, we first study discretionary fiscal policy in a model economy that has only lump-sum taxes.
Lump-sum taxes are taxes that do not vary with real GDP.

19. Fiscal Policy Multipliers
The Government Purchases Multiplier
The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on equilibrium aggregate expenditure and real GDP.
A multiplier exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.

20. Fiscal Policy Multipliers
Figure 11.6 illustrates the government purchases multiplier in the aggregate expenditure diagram.
The government purchases multiplier is 1/(1 – MPC) where MPC is the marginal propensity to consume (absent induced taxes and imports).
Been here before. Point out that the investment multiplier and the government purchases multiplier are identical. And although the lump-sum tax multiplier is different, it builds on the same principle –a change in autonomous expenditure that gets multiplied by that same multiplier. But a dollar of tax hike (or cut) doesn’t translate to a dollar change in autonomous expenditure. The dollar gets multiplied by the MPC, so autonomous expenditure changes by less than a dollar (and in the opposite direction to the tax change).
Circular flow version. Some instructors like to illustrate the difference between the spending multipliers and the tax multiplier using the circular flow diagram and to emphasize that the change in the circular flow occurs at different points. For the change in government purchases (or investment), AE and AD change directly, whereas for a change in taxes, disposable income changes, which brings a smaller change in consumption expenditure in the first round than the change in taxes.

21. Fiscal Policy Multipliers
The Lump-Sum Tax Multiplier
The lump-sum tax multiplier is the magnification effect a change in lump-sum taxes has on equilibrium aggregate expenditure and real GDP.
An increase in lump-sum taxes decreases disposable income, which decreases consumption expenditure and decreases aggregate expenditure and real GDP.

22. Fiscal Policy Multipliers
The amount by which a tax increase lowers consumption expenditure is determined by the MPC.
A $1 tax increase lowers consumption expenditure by $1  MPC, and this amount gets multiplied by the standard autonomous expenditures multiplier.
The lump-sum tax multiplier is –MPC/(1 – MPC).
It is negative because an increase in lump-sum taxes decreases equilibrium expenditure.
Balanced budget multiplier. Although the text doesn’t discuss the balanced budget multiplier, it is a small step and is easily covered if you wish to do so. Formally, just add the two multipliers together 1/(1 – MPC) – MPC/(1 – MPC) = (1 – MPC)/(1 – MPC) = 1. Intuitively, the net increase in autonomous expenditure is (1 – MPC) times the size of the balanced budget change in G and T. And it gets multiplied by 1/(1 – MPC).

23. Fiscal Policy Multipliers
Figure 11.7 illustrates the effect of an increase in lump-sum taxes.
The lump-sum transfer payments multiplier and the lump-sum tax multiplier are the same except for their signs—the transfer payments multiplier is positive.

24. Fiscal Policy Multipliers
Induced Taxes and Entitlement Spending
Taxes that vary with real GDP are called induced taxes.
Most transfer payments are entitlement spending, which also vary with real GDP.
During a recession, induced taxes fall and entitlement spending rises; and during an expansion, induced taxes rise and entitlement spending falls.
Both effects diminish the size of the government purchases and lump-sum tax multipliers.
Been here before again! The discussion of the impact of induced taxes and imports on the size of the multiplier also repeats material in Chapter 25, but is worth emphasizing again because students often do not fully absorb this at first.
Automatic stabilizers. Automatic stabilizers are worth substantial emphasis. Point out that stabilization doesn’t mean stability! (A ship sways in the waves but by less than it would without its automatic stabilizers.) A little history can help students appreciate the importance of automatic stabilizers. Refer back to the figure of the business cycle throughout the twentieth century in Figure 20.1 (page 455/109), and the data on the length and magnitude of cycles before and after World War II, in Table 20.1 (page 454/108). Then ask students what percentage of income earners paid income tax and Social Security contributions and were covered by unemployment insurance in 1940 compared to after World War II. The inference that it is the structural changes that made automatic stabilizers far more prominent in the U.S. economy will seem clear.

25. Fiscal Policy Multipliers
The extent to which induced taxes and entitlement spending decrease the multiplier depends on the marginal tax rate, which is the fraction of an additional dollar of real GDP that flows to the government in net taxes.
The higher the marginal tax rate, the larger is the fraction of an additional dollar of income that flows to the government and the smaller is the induced change in consumption expenditure.
The smaller the induced change in consumption expenditure the smaller are the government purchases and lump-sum tax multipliers.

26. Fiscal Policy Multipliers
International Trade and Fiscal Policy Multipliers
Imports decrease the fiscal policy multipliers.
The larger the marginal propensity to import, the smaller is the magnitude of the government purchases and lump-sum tax multipliers.

27. Fiscal Policy Multipliers
Automatic Stabilizers
Automatic stabilizers are mechanisms that stabilize real GDP without explicit action by the government.
Income taxes and transfer payments are automatic stabilizers.
Because income taxes and transfer payments change with the business cycle, the government’s budget deficit also varies with this cycle.
In a recession, taxes fall, transfer payments rise, and the deficit grows; in an expansion, taxes rise, transfers fall, and deficit shrinks.

28. Fiscal Policy Multipliers
Figure 11.8 shows the budget deficit over the business cycle for 1981–2001.
Recessions are highlighted.

29. Fiscal Policy Multipliers
The structural surplus or deficit is the surplus or deficit that would occur if the economy were at full employment and real GDP were equal to potential GDP.
The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit; that is, it is the surplus or deficit that occurs purely because real GDP does not equal potential GDP.
Cyclical and structural budget balances. Cyclical and structural budget balances are a difficult concept for many students, but important because of the appropriate measure of fiscal stance.
An effective way to help students see that tax revenues and expenditures will vary as depicted in Figure 11.9 (page 615/269) is to remind them that potential GDP corresponds to full employment, and employment (and thus the number of tax payers and recipients of unemployment compensation) changes when GDP varies.

30. Fiscal Policy Multipliers
Figure 11.9 illustrates the distinction between a structural and cyclical surplus and deficit.
In part (a), as real GDP fluctuates around potential GDP, a cyclical deficit or surplus arises.

31. Fiscal Policy Multipliers
In part (b), as potential GDP grows, a structural deficit becomes a structural surplus.

32. Fiscal Policy Multipliers and the Price Level
Fiscal Policy and Aggregate Demand
Figure illustrates the effects of fiscal policy on aggregate demand.
An increase in government purchases shifts the AE curve upward and shifts the AD curve rightward.
Been here before yet again! After calculating the simple multipliers in the AE model, we now need to remind students that in the real world the price level varies, so we need to extend the analysis into the AS-AD model. Again, the analysis is exactly parallel to that in Chapter 25 on investment multipliers. The distinction between short-run and long-run impacts are important, as is the issue of timing and lags and institutional structures.

33. Fiscal Policy Multipliers and the Price Level
The magnitude of the shift in the AD curve equals the government purchases multiplier times the increase in government purchases.
When lump-sum taxes decrease, the rightward shift in the AD curve equals the lump-sum tax multiplier times the reduction in taxes.

34. Fiscal Policy Multipliers and the Price Level
Expansionary fiscal policy, an increase in government expenditures or a decrease in tax revenues, shifts the AD curve rightward.
Contractionary fiscal policy, a decrease in government expenditures or an increase in tax revenues, shifts the AD curve leftward.

35. Fiscal Policy Multipliers and the Price Level
Figure 11.11(a) illustrates the effect of an expansionary fiscal policy on real GDP and the price level when real GDP is below potential GDP.
The rightward shift in the AD curve equals the multiplied increase in aggregate expenditure.

36. Fiscal Policy Multipliers and the Price Level
The increase in GDP is less than the multiplied increase in aggregate expenditure because the price level rises.

37. Fiscal Policy Multipliers and the Price Level
Fiscal Expansion at Potential GDP
In Figure 11.11(b) illustrates the effects of an expansionary fiscal policy at full employment.
Crowding-out at full employment. The text introduces the crowding-out effect in Chapter 23 and doesn’t discuss it in this chapter. But you can easily reinforce the idea in the full employment analysis. If Y = potential GDP, an increase in G must crowd out something because Y = C + I + G + X – M. C and M depend (primarily) on Y, so they don’t change (much). Exports depend primarily on the buying plans of foreigners. That leaves I as the main item that gets crowded out by an increase in G at full employment.

38. Fiscal Policy Multipliers and the Price Level
In the long run, fiscal policy multipliers are zero because real GDP equals potential GDP and a change in aggregate demand changes the money wage rate, the SAS curve, and the price level.

39. Fiscal Policy Multipliers and the Price Level
Limitations of Fiscal Policy
Because the short-run fiscal policy multipliers are not zero, fiscal policy can be used to help stabilize the economy.
But in practice, fiscal policy is hard to use because:
The legislative process is too slow to permit policy actions to be implemented when they are needed.
Potential GDP is hard to estimate, so too much fiscal stimulation might be applied too close to full employment.
Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. Chapter 31 discusses this difficulty in detail, but it is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long, drawn-out process. An increase in government purchases shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the differences between the potential of fiscal policy under a parliamentary system and under the U.S. system; the length of time it took the Congress to pass the 2002 ‘stimulus’ package, compared to almost immediate executive-initiated changes to fiscal policy in Canada and Western Europe, make the point that discretionary fiscal policy is feasible under some governmental systems but only in extreme circumstances in the United States.

40. Supply-Side Effects of Fiscal Policy
Fiscal Policy and Potential GDP
Potential GDP depends on the full-employment quantity of labor, which in turn is influenced by the income tax.
Figure on the next slide illustrates the effect of the income tax in the labor market.
This section has been changed to make more explicit the distinction between short-run effects (largely through labor market effects) and long-run growth effects. You will want to skip the formal analysis in this section if you have not yet covered Chapters 22 and 23. You can cover this section when you cover those two chapters or omit it.

41. Supply-Side Effects of Fiscal Policy
The income tax decreases the supply of labor because it decreases the after-tax wage rate.
Because the income tax decreases the supply of labor, it raises the equilibrium wage rate, decreases employment, and decreases potential GDP.

42. Supply-Side Effects of Fiscal Policy
This supply-side effect of the income tax means that a cut in the income tax rate increases potential GDP and increases aggregate supply.

43. Supply Side Effects of Fiscal Policy
Figure illustrates two views about the effects of a tax cut on real GDP and the price level.
A tax cut increases aggregate demand and the AD curve shifts rightward.
WRONG FIG ON THESE SLIDES

44. Supply-Side Effects of Fiscal Policy
Most economists believe that a tax cut has a small effect on aggregate supply.
So GDP increases and the price level rises.

45. Supply-Side Effects of Fiscal Policy
Supply-side economists think that a tax cut increases aggregate supply by a large amount so that GDP increases and the price level does not change (or might even fall).

46. Supply-Side Effects of Fiscal Policy
Fiscal Policy and Economic Growth
Fiscal policy also influences economic growth by changing the incentives to save, invest, and innovate.
These incentives work similarly to those in the labor market.
Fiscal policy can also influence growth and the well-being of future generations by crowding out investment and increasing foreign debt.

47. Supply-Side Effects of Fiscal Policy
Figure illustrates some of these effects.
An increase in government purchases or a tax cut decreases world saving and increases the world equilibrium real interest rate.

48. Supply-Side Effects of Fiscal Policy
The increase in government purchases or a tax cut decreases domestic saving and increases international borrowing.

49. 11
FISCAL POLICY
CHAPTER
THE END