1. Chapter 13 Fiscal Policy

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-2 Introduction In the early 2000s the Japanese government sought to cut taxes and increase spending. By early 2004 it launched plans for increasing taxes then in 2005 contemplated cutting them again. In this chapter, you will learn about policy time lags, which contributed to the Japanese government’s on-again, off- again tax policies.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-3 Learning Objectives Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policy Discuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions Explain why the Ricardian equivalence theorem calls into question the usefulness of tax changes

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-4 Learning Objectives (cont'd) List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal “fine tuning” Describe how certain aspects of fiscal policy function as automatic stabilizers for the country

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-5 Chapter Outline Discretionary Fiscal Policy Possible Offsets to Fiscal Policy Discretionary Fiscal Policy in Practice: Coping with Time Lags Discretionary Fiscal Policy in Practice: Coping with Time Lags Automatic Stabilizers What Do We Really Know About Fiscal Policy? What Do We Really Know About Fiscal Policy?

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-6 Did You Know That... Since the early 2000s, total government spending has increased at a rate of about 8% per year? This is the largest annual rate of growth since the 1940s and 1950s? There are consequences of higher government spending for equilibrium real GDP and the price level?

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-7 Discretionary Fiscal Policy  The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals is the realm of fiscal policy.  High employment (low unemployment)  Price stability  Economic growth  Improvement of international payments balance

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-8 Discretionary Fiscal Policy (cont'd) Fiscal Policy  The discretionary changing of government expenditures or taxes to achieve national economic goals, such as high employment with price stability

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-9 Discretionary Fiscal Policy (cont'd) An increase in government spending will stimulate economic activity Changes in government spending  Military spending  Education spending  Budgets for government agencies

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-10 Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a) If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-11 Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b) If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-12 Discretionary Fiscal Policy (cont'd) Questions  Would the increase in government spending equal the size of the gap?  What impact would expansionary fiscal policy have on the price level?

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-13 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E 1, where real GDP exceeds long-run equilibrium Contractionary fiscal policy can move aggregate demand to AD 2 via a tax increase A new equilibrium is at E 2 at a lower price level Real GDP is now consistent with LRAS

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-14 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b) In panel (b) with a recessionary gap (in this case $500 billion) taxes are cut AD 1 moves to AD 2 The economy moves from E 1 to E 2, and real GDP is now at $12 trillion per year We are at the long-run equilibrium level

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-15 Discretionary Fiscal Policy (cont'd) Change in taxes  A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports.

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-16 Discretionary Fiscal Policy (cont'd) Question  What would be the long-run impact of a tax cut on real GDP if the economy is at full- employment equilibrium?

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-17 Possible Offsets to Fiscal Policy Fiscal policy does not operate in a vacuum and important questions must be answered.  How are expenditures financed and by whom?  If taxes are increased what does government do with the taxes?  What will happen if individuals worry about increases in future taxes?

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-18 Possible Offsets to Fiscal Policy (cont'd) Crowding-Out Effect  The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-19 Figure 13-3 The Crowding-Out Effect, Step by Step

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-20 Figure 13-4 The Crowding-Out Effect Expansionary policy causing deficit spending initially shifts from AD 1 to AD 2 Due to crowding out, AD shifts inward to AD 3 Equilibrium GDP below full-employment GDP—recessionary gap

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-21 Possible Offsets to Fiscal Policy (cont'd) Planning for the future: the Ricardian equivalence theorem  Ricardian Equivalence Theorem  The proposition that an increase in the government budget deficit has no effect on aggregate demand

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-22 Possible Offsets to Fiscal Policy (cont'd) Planning for the future: The Ricardian equivalence theorem  The reason for the offset  People anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly.

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-23 Possible Offsets to Fiscal Policy (cont'd) Direct Expenditure Offsets  Actions on the part of the private sector in spending income that offset government fiscal policy actions  Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset.

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-24 International Policy Example: Britain Pays Up but Receives Little Economic Payoff The United Kingdom makes the third highest net contribution to the EU budget, even though EU expenditures contribute so little to total planned spending in that nation. How do taxes that British residents pay to fund their government’s contribution to the EU budget affect aggregate demand in the United Kingdom?

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-25 Possible Offsets to Fiscal Policy (cont'd) The supply-side effects of changes in taxes  Expansionary fiscal policy could involve reducing marginal tax rates.  Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more.  The increased productivity will lead to more economic growth.

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-26 Possible Offsets to Fiscal Policy (cont'd) Supply-Side Economics  The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-27 Possible Offsets to Fiscal Policy (cont'd) Question  Would a tax increase cause you to work more or less?

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-28 Figure 13-5 Laffer Curve Tax rates and tax revenues rise together Tax revenues are at a maximum Tax rates and tax revenues fall together

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-29 Policy Example: A Laffer Curve in the Mid-2000s? In 2003 Congress reduced the top tax rate on corporate dividends and the tax rate on capital gains along with cutting personal income tax rates slightly. Many critics predicted that the federal government’s tax revenues would plummet after these rates were cut.

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-30 Policy Example: A Laffer Curve in the Mid-2000s? (cont'd) By the middle of 2006, after three years of higher real GDP growth, total federal income tax receipts from corporations and individuals had increased by nearly 40%. Why do you suppose it is difficult to determine exactly which factors are most responsible for the increase?

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-31 Discretionary Fiscal Policy in Practice: Coping with Time Lags Question  Is fiscal policy as precise as it appears?

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-32 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags  Recognition Time Lag  The time required to gather information about the current state of the economy

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-33 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags  Action Time Lag  The time required between recognizing an economic problem and putting policy into effect  Particularly long for fiscal policy which requires congressional approval

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-34 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags  Effect Time Lag  The time it takes for a fiscal policy to affect the economy

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-35 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Fiscal policy time lags are long and a policy designed to correct a recession may not produce results until the economy is experiencing inflation. Fiscal policy time lags are variable in length (1–3 years), and the timing of the desired effect cannot be predicted.

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-36 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-37 Automatic Stabilizers Automatic or Built-In Stabilizers  Changes in government spending and taxation that occur automatically without deliberate action of Congress  The tax system  Unemployment compensation  Welfare spending

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-38 Figure 13-6 Automatic Stabilizers The automatic changes tend to drive the economy back toward its full- employment output level

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-39 What Do We Really Know About Fiscal Policy? Fiscal policy during normal times  Congress ends up doing too little too late to help in a minor recession.  Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty.

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-40 What Do We Really Know About Fiscal Policy? (cont'd) Fiscal policy during abnormal times  Fiscal policy can be effective  The Great Depression—fiscal policy may be able to stimulate aggregate demand.  Wartime—during World War II real GDP increased dramatically.

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-41 What Do We Really Know About Fiscal Policy? (cont'd) The “soothing” effect of Keynesian fiscal policy  Should we encounter a severe downturn, fiscal policy is available.  Knowing this may reassure consumers and investors.  Stable expectations encourage a smoothing of investment spending.

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-42 Issues and Applications: The Roller Coaster of Japanese Tax Policy Between 2000 and 2002, the average rate of growth in total expenditures on goods and services in Japan was 0%. In an effort to boost aggregate demand amid a slumping economy the Japanese government cut taxes to spur growth. By the end of 2004 the Japanese government found it was spending nearly twice as much as it was receiving in tax revenues, financing the rest by borrowing.

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-43 Figure 13-7 Government Spending and Tax Revenues in Japan

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-44 Issues and Applications: The Roller Coaster of Japanese Tax Policy (cont'd) Recognition lag  The period between 2003 when aggregate demand began to pick up and 2004 when the government recognized it is called a recognition lag. Action lag  In 2004 the government began a plan to phase in tax increases between 2005 and 2007.

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-45 Issues and Applications: The Roller Coaster of Japanese Tax Policy (cont'd) The roller coaster ride continues  In 2005, the Japanese government gradually phased in the first scheduled tax increase.  Spending fell and new information showed total expenditures had increased at a rate of less than 1% in 2005.

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-46 Issues and Applications: The Roller Coaster of Japanese Tax Policy (cont'd) The roller coaster ride continues  Tax increases slated for 2006 and 2007 threatened to reduce aggregate demand even further.  During 2006 the Japanese government began rethinking its policy options once more and the cycle began anew.

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-47 Summary Discussion of Learning Objectives The effects of discretionary fiscal policy using traditional Keynesian analysis  Increases in government spending and decreases in taxes increase aggregate demand.  Decreases in government spending and increases in taxes decrease aggregate demand.

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-48 Summary Discussion of Learning Objectives (cont'd) How indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions  Deficits increase interest rates.  Some government spending replaces private spending. On net, if the Ricardian equivalence theorem is valid, a tax cut has no effect on total planned expenditures and aggregate demand.

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-49 Summary Discussion of Learning Objectives (cont'd) Fiscal policy time lags and the effectiveness of fiscal “fine tuning”  The time lags for fiscal policy are the recognition time lag, action time lag, and the effect time lag.  The time lags are long and variable. Automatic stabilizers are changes in tax payments, unemployment compensation, and welfare payments that automatically change with the level of economic activity.

50. End of Chapter 13 Fiscal Policy