Download Fiscal Policy: Incentives and Secondary Effects

Chapter 12

Compare and contrast macroeconomic
theories about expansionary fiscal policy
◦ Keynesian Theory
◦ Crowding Out
◦ New Classical


Use supply-side economics to discuss the
difference between a tax cut and an increase
in government spending
Summarize the agreements and
disagreements about fiscal policy among
modern macroeconomists
The main difference between Keynes and
modern economics if the focus on incentives.
Keynes studied the relation between
macroeconomic aggregates, without any
consideration for the underlying incentives that
lead to the formation of these aggregates. By
contrast, modern economists base all their
analysis on incentives.
--Luigi Zingales



During a recession, the government should
 Cut taxes and/or increase government
spending
 This means running a budget deficit
Keynes said this will stimulate AD and shift it
right
…Other economists disagree! Where does
the money come from?


Crowding out – a reduction in private
spending as a result of budget deficits
financed by borrowing in the private loanable
funds market
Expansionary fiscal policy financed by deficit
borrowing will lead to
◦ Higher interest rates
◦ No impact on AD, output, or unemployment


Implies that expansionary fiscal policy won’t
restore the economy to full employment
during a recession
When interest rates rise, private investment is
crowded out
◦ Output of capital goods falls
◦ Reduces long-run economic growth rates
Government
borrowing increases
the demand for
loanable funds
S1
Real Interest Rate
r2
r1
Higher real interest
rates reduce private
investment and
consumption
D2
D1
Q1
Q2
Loanable Funds
Price Level
SRAS
AD is unchanged
because higher interest
rates reduced private
spending
P1
AD
Y1
Goods and Services
(real GDP)
Government budget deficit  trade deficit!


Implies that restrictive fiscal policy won’t
dampen inflation during an expansion
Crowding in means restrictive fiscal policy
and budget surpluses will lead to
◦ Lower interest rates
◦ No impact on AD, output, or unemployment


Similar to classical economists, believe
economy tends toward full employment
Government borrowing
◦ Shifts the timing of taxes, but not their magnitude
◦ Interest payments

In the loanable funds market
◦ Demand increases (b/c of higher gov’t borrowing)
◦ Supply increases (b/c of more private saving)


Ricardian Equivalence – the theory that
raising taxes and running a budget deficit are
essentially equivalent and will have no impact
on consumption or AD
New Classical Economists believe that
expansionary fiscal policy financed by a
deficit will lead to
◦ No change in interest rates
◦ No impact on AD, output, or unemployment
Government
borrowing increases
the demand for
loanable funds
S1
Households understand
that future taxes will
be higher and increase
their savings
Real Interest Rate
S2
r1, r2
D2
D1
Q1
Q2
Loanable Funds
Price Level
SRAS
AD is unchanged
because the increase in
gov’t spending was
offset by an increase in
consumer saving
P1
AD
Y1
Goods and Services
(real GDP)
6.
Beware of the secondary effects: economic
actions often generate indirect as well as
direct effects
Both the crowding-out and new classical
models indicate that secondary effects negate
the stimulating impacts of expansionary fiscal
policy
15

No politician wants to be Debbie Downer!
◦ Spend money to directly benefit constituents
◦ Reluctant to raise taxes

Countercyclical policy is not popular
◦ Budget deficits are more attractive
◦ Budget deficits are much more common than
surpluses

Economists agree
◦ Timing of fiscal policy difficult
◦ Automatic stabilizers help mitigate fluctuations
◦ Budget deficits have secondary impacts

Lower tax rates
◦ Increase the incentive to work and invest
◦ Investment causes technological progress and
capital formation
◦ This increases long-run aggregate supply
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Policy for long-run growth
What would you do if your marginal tax rate
were 90%? 70%? 50%? 10%?

Greg Mankiw:
◦
◦
◦
◦
◦

Harvard prof, earns $250,000+
Considers an extra $1,000 with and without taxes
Invest for 30 years, interest rate of 8%
Without taxes: $10,000
With taxes: $1,000
http://www.nytimes.com/2010/10/10/busin
ess/economy/10view.html?_r=3&ref=busines
s&
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High tax rates
◦ Reduce incentive to be productive
◦ Decrease investment
◦ Encourage purchases of fancy tax-deductible stuff!
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Laffer Curve
A reduction in high marginal tax rates can
actually increase tax revenues!
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Keynesians: YES
Non Keynesians: NO
◦ More government debt means higher interest rates
and less economic growth
◦ Increased government spending will be politically
motivated
◦ More politically directed spending leads to more
rent seeking and less wealth creating production

Keynesians
◦ Gov’t spending increase is better than tax cut
◦ Tax cuts can be saved or spent abroad

Non Keynesians
◦ Tax cut better than increase gov’t spending
◦ Tax cuts can be implemented quickly
◦ Tax cuts easier to reverse
Restrictive during the 90s
 Expansionary during and
following recession
 Stimulus

◦ 2008 – $168 billion rebate
checks
◦ 2008 – $700 billion TARP
for financial institutions
◦ 2009 – $787 billion more


Consider Greece, Portugal, Italy, Spain
Canada, Ireland

Compare and contrast macroeconomic
theories about expansionary fiscal policy
◦ Keynesian Theory
◦ Crowding Out
◦ New Classical


Use supply-side economics to discuss the
difference between a tax cut and an increase
in government spending
Summarize the agreements and
disagreements about fiscal policy among
modern macroeconomists