Download Ch 10

Ch. 10: The Federal
Budget and Fiscal Policy
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
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Government Spending as a
Percentage of GDP, 2003
20.5
19.9
20
Percent
19.5
19.4
19.2
19
18.6
18.5
18.6
18.4
18
17.5
1998
1999
2000
2001
2002
2003
Year
2
Dollar Amounts Spent in Various
Spending Programs, 2003
Spending Program Category
Billions of Dollars
National Defense
$404
Social Security
$471
Medicare
$274
Medicaid
$161
Unemployment Compensation
$55
Food Stamps
$25
Family Support
$26
Child Nutrition
$12
Veterans' Benefits
$29
Federal Civilian Retirement
Benefits
$58
Administration of Justice
$35
Science, space and technology
$20
Agriculture
$22
Net Interest on the Public Debt
$153
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Government Tax Revenues as a
Percentage of GDP, 2003
25.0
20.0
20.0
20.9
19.8
Percent
20.0
17.9
16.5
15.0
10.0
5.0
0.0
1998
1999
2000
2001
2002
2003
Year
4
Government Tax Revenues
by Type of Tax, 2003
Tax
Billions of Dollars
Percentage of 2003
GDP
Individual Income Tax
$794
7.3
Corporate Income Tax
$132
1.2
Social Security Taxes
$713
6.6
Other
$143
1.3
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Government Tax Revenues in
Billions of Dollars, 2000-2003
Year
Individual Income
Tax
Corporate Income
Tax
Social
Security
2000
$1,004
$207
$653
2001
$994
$151
$694
2002
$858
$148
$700
2003
$794
$132
$713
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Income Tax Structure



Progressive Income Tax: the tax rate
increases as a person’s taxable income level
rises. A progressive tax is usually capped at
some tax rate.
Proportionate Income Tax: the same tax
rate is used for all levels. This is sometimes
called a flat tax.
Regressive Income Tax: the tax rate
decreases as a person’s taxable income level
rises.
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Exhibit 1: Three Income
Tax Structures
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Who Pays the Tax?
Income
Group
Group's Share of Total
Income
Group's Share of Federal
Income Taxes
Top 1 %
17.5%
33.9%
Top 5 %
32.0%
53.3%
Top 10 %
43.1%
64.9%
Top 25 %
65.2%
82.9%
Top 50 %
86.2%
96.1%
Bottom
50 %
13.8%
3.9%
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The Federal Budget



Budget Deficit: government
expenditures > tax revenues.
Budget Surplus: government
expenditures < tax revenues.
Balanced Budget:
government expenditures = tax
revenues
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Projected U.S Budget
Deficits
Year
Projected Budget Deficit
(billions of dollars)
2005
348
2006
298
2007
308
2008
318
2009
312
2010
298
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Deficits and the Public
Debt




Cyclical deficit: the part of the budget
deficit that is a result of a downturn in
economic activity.
Structural deficit: the part of the budget
deficit that would exist even if the economy
were operating at full employment.
Total Budget Deficit = Cyclical Deficit +
Structural Deficit
Public debt: the total amount the federal
government owes its creditors.
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Fiscal Policy
Fiscal Policy: changes in
government expenditures and/or
taxes to achieve particular
economic goals, such as low
unemployment, price stability, and
economic growth.
13
Fiscal Policy Definitions


Expansionary Fiscal Policy:
Increases in government
expenditures and/or decreases
in taxes to achieve particular
economic goals.
Contractionary Fiscal
Policy: Decreases in
government expenditures
and/or increases in taxes to
achieve macroeconomic goals.
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Fiscal Policy Definitions


Discretionary Fiscal
Policy: deliberate changes
of government expenditures
and/or taxes to achieve
particular economic goals.
Automatic Fiscal Policy:
changes in government
expenditures and/or taxes
that occur automatically
without (additional)
congressional action.
15
Two Key Assumptions


Only deal with discretionary fiscal
policy.
Any change in government spending is
due to a change in government
purchases and not to a change in
transfer payments.
16
Demand-Side Fiscal Policy


A change in consumption, investment,
government purchases, or net exports
can change aggregate demand and
therefore shift the AD curve.
A change in taxes can affect
consumption or investment or both
and therefore can affect aggregate
demand.
17
Exhibit 2: Fiscal Policy in Keynesian
Theory: Ridding the Economy of
Recessionary and Inflationary Gaps
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Crowding Out

Refers to a decrease in private expenditures
that occurs as a consequence of increased
government spending or the financing
needs of a budget deficit.
– Direct substitution of public spending for
private spending.
– A drop in investment due to a higher
interest rate from financing the deficit.
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Crowding Out


Complete Crowding Out: a decrease
in one or more components of private
spending completely offsets the
increase in government spending.
Incomplete Crowding Out: the
decrease in one or more components of
private spending only partially offsets
the increase in government spending.
20
Exhibit 3: Zero (No), Incomplete, and
Complete Crowding Out
21
Exhibit 4: Expansionary Fiscal Policy
(Government Spending Increases),
Crowing Out, and Changes in Real
GDP and the Unemployment Rate
22
The New Classical View of
Fiscal Policy


Current consumption will fall as a
result of expansionary fiscal policy.
Deficits do not necessarily bring
higher interest rates.
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Exhibit 5: The New Classical View of
Expansionary Fiscal Policy
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Lags And Fiscal Policy
1.
2.
3.
4.
5.
The
The
The
The
The
Data Lag
Wait-And-See Lag
Legislative Lag
Transmission Lag
Effectiveness Lag
25
Exhibit 6: Fiscal Policy May
Destabilize the Economy
26
Self-Test



How does crowding out question the
effectiveness of expansionary demand-side
fiscal policy?
According to new classical economists, how
do individuals respond to larger deficits?
What changes do they anticipate in the
credit or loanable funds market as a result
of a larger deficit?
How might lags reduce the effectiveness of
fiscal policy?
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Supply-Side Fiscal Policy



Ceteris Paribus, lower marginal tax
rates increase the incentive to engage
in productive activities relative to leisure
and tax avoidance activities.
Marginal Tax Rate = (Δ Tax payment)
(Δ Taxable Income)
Average Tax Rate = Total tax payment
Taxable Income
28
Exhibit 7: The Predicted Effect of a Permanent
Marginal Tax Rate Cut on Aggregate Supply
29
The Laffer Curve: Tax
Rates and Tax Returns





If income tax rates were lowered, would it
increase or decrease tax revenue?
There are two tax rates at which zero tax
revenues will be collected – 0 and 100%.
An increase in tax rates could cause tax
revenues to increase.
A decrease in tax rates could cause tax
revenues to increase.
Tax revenues = (Tax base) x (the average
Tax rate)
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Exhibit 8: The Laffer Curve
31
Exhibit 9: Tax Rates, the Tax
Base, and Tax Revenues
32
Macroeconomics
Intermission
1.
2.
3.
How Does the
Economy Work?
Is it Self-regulating?
Is it Inherently
unstable?
Will a fiscal policy
have its intended
effect?
33
Self-Test


Give an arithmetical example to
illustrate the difference between the
marginal and average tax rates.
If income tax rates rise, will income
tax revenue rise as well?
34
Exhibit 10: Macroeconomists’ Views on
Two Issues: How the Economy
Works and the Effectiveness of
Fiscal Policy
35
Coming Up (Ch. 11): More on
Government Spending and Taxes:
Beyond Fiscal Policy
36