1. c h a p t e r seventeen © 2007 Prentice Hall Business Publishing Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien Prepared by: Fernando & Yvonn Quijano Fiscal Policy

2. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 2 of 32 After studying this chapter, you should be able to: Define fiscal policy. Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy. Explain how the multiplier process works with respect to fiscal policy. Discuss the difficulties that can arise in implementing fiscal policy. Explain how the federal budget can serve as an automatic stabilizer. Discuss the long-run effects of fiscal policy. A Boon for H&R Block LEARNING OBJECTIVES 1 2 3 5 In this chapter, we will explore how the government uses fiscal policy, which involves changes in taxes and changes in government purchases… 4 6

3. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 3 of 32 Fiscal Policy LEARNING OBJECTIVE 1 Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. What Fiscal Policy Is and What It Isn’t Automatic Stabilizers versus Discretionary Fiscal Policy Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle.

4. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 4 of 32 Fiscal Policy 17 - 1 The Federal Government’s Share of Total Government Expenditures, 1929-2004 An Overview of Government Spending and Taxes

5. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 5 of 32 Fiscal Policy 17 - 2 Federal Purchases and Federal Expenditures as a Percentage of GDP, 1929-2004 An Overview of Government Spending and Taxes

6. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 6 of 32 Fiscal Policy An Overview of Government Spending and Taxes 17 - 3 Federal Government Expenditures, 2004

7. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 7 of 32 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.

8. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 8 of 32 Employment Act of 1946 The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments,... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self- employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.

9. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 9 of 32 Employment Act of 1946 The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments,... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self- employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.

10. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 10 of 32 Employment Act of 1946 The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments,... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self- employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.

11. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 11 of 32 Employment Act of 1946 The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments,... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self- employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.

12. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 12 of 32 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.

13. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 13 of 32 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.

14. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 14 of 32 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.

15. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 15 of 32 The Federal Budget

16. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 16 of 32 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.

17. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 17 of 32 The Federal Budget Figure below shows the evolution of the debt as a percentage of GDP since 1942.

18. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 18 of 32 The Federal Budget State and Local Budgets In 2002, when the federal government spent $2,000 billion, state and local governments spent almost $1,900 billion, mostly on education, protective services, and roads. State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.

19. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 19 of 32 National Debt/GDP

20. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 20 of 32 Who Is Debt Owed To?

21. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 21 of 32 National Debt National Debt – Some Simple Calculations National Debt January 2007per capita ($000) (Pop = 300m) Publicly-held USA26748.9 Publicly-held-foreign22407.5 US Government held379412.6 Total870829.0 Net Debt Publicly-held USA26748.9 Foreign-held22407.5 Total491416.4 Foreign debt as % of net debt45.6%

22. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 22 of 32 The Future of Social Security and Medicare 17 - 1 Will the federal government be able to keep the promises made by the Social Security and Medicare programs?

23. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 23 of 32 Fiscal Policy 17 - 4 Federal Government Revenue, 2004 An Overview of Government Spending and Taxes

24. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 24 of 32 Using Fiscal Policy to Influence Aggregate Demand LEARNING OBJECTIVE 2 17 - 5 An Expansionary Fiscal Policy Expansionary Fiscal Policy

25. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 25 of 32 Using Fiscal Policy to Influence Aggregate Demand 17 - 6 A Contractionary Fiscal Policy Contractionary Fiscal Policy

26. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 26 of 32 Using Fiscal Policy to Influence Aggregate Demand A Summary of How Fiscal Policy Affects Aggregate Demand PROBLEMTYPE OF POLICY ACTIONS BY CONGRESS AND THE PRESIDENTRESULT RecessionExpansionaryIncrease government spending or cut taxes Real GDP and the price level rise Rising Inflation ContractionaryDecrease government spending or raise taxes Real GDP and the price level fall Countercyclical Fiscal Policy 17 – 1 Don’t Confuse Fiscal Policy and Monetary Policy

27. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 27 of 32 The Government Purchases and Tax Multipliers LEARNING OBJECTIVE 3 17 - 7 The Multiplier Effect and Aggregate Demand Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

28. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 28 of 32 The Government Purchases and Tax Multipliers 27 - 8 The Multiplier Effect of an Increase in Government Purchases 17 - 8

29. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 29 of 32 The Government Purchases and Tax Multipliers

30. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 30 of 32 The Government Purchases and Tax Multipliers The Effect of Changes in Tax Rates Taking Into Account the Effects of Aggregate Supply 17 - 9 The Multiplier Effect and Aggregate Supply

31. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 31 of 32 The Government Purchases and Tax Multipliers The Multipliers Work in Both Directions Fiscal Policy Multipliers 17-1 LEARNING OBJECTIVE 3

32. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 32 of 32 The Limits of Using Fiscal Policy to Stabilize the Economy LEARNING OBJECTIVE 4 17 - 10 How a Bill Becomes Law

33. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 33 of 32 The Limits of Using Fiscal Policy to Stabilize the Economy Does Government Spending Reduce Private Spending? Crowding out A decline in private expenditures as a result of an increase in government purchases.

34. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 34 of 32 The Limits of Using Fiscal Policy to Stabilize the Economy 17 - 11 An Expansionary Fiscal Policy Increases Interest Rates Crowding Out in the Short Run

35. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 35 of 32 The Limits of Using Fiscal Policy to Stabilize the Economy 17 - 12 The Effect of Crowding Out in the Short Run Crowding Out in the Short Run Crowding Out in the Long Run

36. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 36 of 32 Limits to Fiscal Policy: Japan in the Late 1990s 17 - 2 Fiscal policy in Japan has not been effective in expanding real GDP and reducing unemployment.

37. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 37 of 32 Deficits, Surpluses, and Federal Government Debt LEARNING OBJECTIVE 5 Budget deficit The situation in which the government’s spending is greater than its tax revenue. Budget Surplus The situation in which the government’s expenditures are less than its tax revenue.

38. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 38 of 32 Deficits, Surpluses, and Federal Government Debt 17 - 13 The Federal Budget Deficit, 1901-2004 How the Federal Budget Can Serve as an Automatic Stabilizer

39. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 39 of 32 Deficits, Surpluses, and Federal Government Debt Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP. 17 – 14 How the Level of GDP Affects the Cyclically Adjusted Budget Deficit How the Federal Budget Can Serve as an Automatic Stabilizer

40. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 40 of 32 Did Fiscal Policy Fail During the Great Depression? 17 - 3 Although government spending increased during the Great Depression, the cyclically adjusted budget was in surplus most years. FEDERAL GOVERNMENT EXPENDITURES (BILLIONS OF DOLLARS ACTUAL FEDERAL BUDGET DEFICIT OR SURPLUS (BILLIONS OF DOLLARS) CYCLICALLY ADJUSTED BUDGET DEFICIT OR SURPLUS (BILLIONS OF DOLLARS) CYCLICALLY ADJUSTED BUDGET DEFICIT OR SURPLUS AS A PERCENTAGE OF GDP 1929$2.6$1.0$1.241.20% 19302.70.20.810.89 19314.0-2.1-0.41-0.54 19323.0-1.30.500.85 19333.4-0.91.061.88 19345.5-2.20.090.14 19355.6-1.90.540.74 19367.8-3.20.470.56 19376.40.22.552.77 19387.3-1.32.472.87 19398.4-2.12.002.17

41. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 41 of 32 Deficits, Surpluses, and Federal Government Debt Should the Federal Budget Always Be Balanced? The Effect of Economic Fluctuations on the Budget Deficit 17-2 LEARNING OBJECTIVE 5

42. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 42 of 32 Deficits, Surpluses, and Federal Government Debt The Federal Government Debt Is the Government Debt a Problem? 17 - 15 The Federal Government Debt, 1901-2004

43. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 43 of 32 The Effects of Fiscal Policy in the Long Run LEARNING OBJECTIVE 6 Tax wedge The difference between the pre-tax and post-tax return to an economic activity. The Long-Run Effects of Tax Policy We can briefly look at the effects on aggregate supply of cutting each of the following taxes:  Individual income tax.  Corporate income tax.  Taxes on dividends and capital gains. Tax Simplification

44. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 44 of 32 Should the United States Adopt the “Flat Tax”? 17 - 4 Should the United States simplify the tax code by moving to a flat tax? COUNTRY FLAT TAX RATE YEAR FLAT TAX WAS INTRODUCED Estonia26%1994 Lithuania331994 Latvia251995 Russia132001 Serbia142003 Ukraine132004 Slovakia192004 Georgia122005 Romania162005

45. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 45 of 32 The Effects of Fiscal Policy in the Long Run The Economic Effect of Tax Reform 17 - 15 The Supply-Side Effects of a Tax Change How Large Are Supply-Side Effects?

46. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 46 of 32 The Not-So-Incredible Shrinking Deficit

47. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 47 of 32 Automatic stabilizers Budget deficit Budget surplus Crowding out Cyclically adjusted budget deficit or surplus Fiscal policy Multiplier effect Tax wedge

48. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 48 of 32 National Debt/GDP

49. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 49 of 32 Who Is Debt Owed To?

50. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 17: Fiscal Policy 50 of 32 National Debt National Debt – Some Simple Calculations National Debt January 2007per capita ($000) (Pop = 300m) Publicly-held USA26748.9 Publicly-held-foreign22407.5 US Government held379412.6 Total870829.0 Net Debt Publicly-held USA26748.9 Foreign-held22407.5 Total491416.4 Foreign debt as % of net debt45.6%