© 2010 Jane Himarios, Ph.D. Lecture 10 Chapter 10: Fiscal Policy The Federal Budget (we will study this in more detail in Chapter 13) Economists understand that government intervention in the economy has important effects on the federal government’s budget. Definitions: 1. G = government expenditures, including transfer payments 2. T = government tax receipts 3. The budget is balanced if G=T. 4. A budget surplus exists if G < T. 5. A budget deficit exists if G > T. To see the federal budget go to http://www.fms.treas.gov. Under the heading "Publications" find the "Monthly Treasury Statement." Choose a format (PDF or ASCII) and then scroll down to Table 2. Here is a summary for FY2009 from http://fms.treas.gov/mts/Treasury0909.pdf (issued October 2009): © 2010 Jane Himarios, Ph.D. How did this change from the previous year? To see, go to http://www.fms.treas.gov/annualreport/index.html and scroll down to Part One, Financial Highlights (PDF file): © 2010 Jane Himarios, Ph.D. Go to http://www.cbo.gov/ftpdocs/108xx/doc10871/historicaltables.pdf to view the federal budget surpluses and deficits for the last 40 years. Fill this in (in Billions of Dollars): Year Revenues Outlays On-Bud SS Postal Total Debt Held by the Public 2009 Read John D. McKinnon, “Deficit of $1.4 Trillion Limits Democrats,” WSJ, 10/17/2009, especially “The Treasury Department reported that the deficit for the 2009 fiscal year ended Sept. 30 came in at about $1.4 trillion, or about 10% of the U.S.'s gross domestic product.” (Note: We will talk about on-budget versus off-budget versus total budget numbers when we get to chapter 13.) © 2010 Jane Himarios, Ph.D. I. Types of Government Spending Go to www.cbo.gov/budget/data/historical.pdf (page 5) to see discretionary and mandatory spending levels. © 2010 Jane Himarios, Ph.D. II. Fiscal Policy and AD A. Discretionary Fiscal Policy Discretionary fiscal policy involves adjusting government spending and tax policies to increase aggregate demand with the goal of moving the economy toward full employment (a short run goal), expanding economic growth, or controlling inflation. 1. Expansionary Fiscal Policy a. In Depression Period: when AD↑→P _____ Q _____ U _____ b. In a recession: when AD↑→P _____ Q _____ U _____ c. At full employment: when AD↑→ initially, P _____ Q _____ U _____, but eventually P _____ Q _____ U _____ 2. Contractionary Fiscal Policy a. In a period of inflation: when AD↓→P _____ Q _____ U _____ b. At full employment: when AD↓→ initially, P _____ Q _____ U _____, but eventually P _____ Q _____ U _____ III. Fiscal Policy and AS Supply-side fiscal policy is implemented to shift the LRAS curve rightward in order to achieve economic growth without increasing inflationary pressures. Supply-side policies are designed to encourage economic growth. Examples: 1. Building and improving infrastructure 2. Setting up a fair and efficient legal system 3. Setting up a stable financial system 4. Improving the education system 5. Increasing research and development 6. Cutting marginal income tax rates to increase production by workers 7. Cutting marginal business tax rates to increase investment by firms 8. Reducing regulations to increase investment by firms Preliminary information before studying #6 and #7: Income Tax Systems Economists have figured out that income tax systems can affect household behavior in addition to affecting how much revenue the government is able to raise. It is useful to know whether a tax system is proportional, progressive, or regressive with respect to income. © 2010 Jane Himarios, Ph.D. Marginal income is the extra income that kicks you into a different tax bracket. The Marginal income tax rate measures the percentage of extra income that you pay in taxes. Progressive Income Tax: An income tax system where the marginal tax rate rises as taxable income rises. Proportional Income Tax: An income tax system where everyone pays the same tax rate, regardless of income (that, is, where the marginal rate stays the same). Regressive Income Tax: An income tax system where the marginal tax rate falls as taxable income rises. Example: Income Over $0 but not over $500 Over $500 but not over $1000 Over $1000 Marginal Tax Rate 5% Taxes 5% of taxable income 30% $25 + 30% of everything over $500 $175 + 60% of everything over $1000 60% In this table the $501st dollar kicks you into the 30% bracket. The $1001st dollar kicks you into the 60% bracket. Describe this tax system: This tax system is ______________ with respect to income. Let’s see the tax bills for people with different incomes under this tax system: Income Tax Bill Calculation Tax Bill $1 $1 x .05 $0.05 $2 $2 x .05 $0.10 $500 $500 x .05 $25 $501 ($500 x .05) + ($1 x .30) $25.30 $502 ($500 x .05) + ($2 x .30) $25.60 $1000 ($500 x .05) + ($500 x .30) $175 $1001 ($500 x .05) + ($500 x .30) + ($1 x $175.60 .60) $1002 ($500 x .05) + ($500 x .30) + ($2 x $176.20 .60) See http://www.taxfoundation.org/taxdata/show/151.html for the 2010 income tax brackets: © 2010 Jane Himarios, Ph.D. Income Over $0 but not over $________ Over $________ but not over $________ Over $________ but not over $________ Over $________ but not over $________ Over $________ but not over $________ Over $________ Marginal Tax Rate The U.S. income tax system is progressive. Progressive income tax systems reduce efficiency. Higher marginal tax rates reduce incentives to work and to invest in the education needed to get high-paying jobs, and this reduces the amount of goods and services that are produced. Marginal Income Tax Rates and Aggregate Supply Two things happen if the government lowers marginal tax rates: 1. incentives to work increase (this affects output, employment, the price level, and tax revenue) 2. incentives to engage in tax-avoidance activities decrease (this affects tax revenue) What happens to output, employment and the price level when marginal tax rates are lowered? Principle of Economics: Lowering marginal tax rates leads to more output and employment and to a lower price level, ceteris paribus. Increased incentives to work causes the SRAS curve to shift to the right. This leads to more output, more employment, and a lower price level, ceteris paribus. If the lower marginal tax rates are permanent, this also causes the LRAS curve to shift to the right. This leads to more output, more employment, and a lower price level, ceteris paribus. What happens to tax revenue when marginal tax rates are lowered? Answer: It depends where on the Laffer Curve the economy is located. An economist named Arthur Laffer figured out that lowering marginal tax rates will lead to more tax revenue if the economy is operating in the negatively sloped portion of the Laffer Curve, but less tax revenue if the economy is operating in the positively sloped portion of the Laffer Curve. In the simplest form: (-) © 2010 Jane Himarios, Ph.D. Tax Revenue = Tax Base x Tax Rate, where the Tax Base = f(Tax Rate) Tax Revenue B A C Tax Rate Example 1: Use the information from the first two columns to calculate tax revenue and then draw a Laffer curve based on this tax system: Remember that Tax Revenue = Tax Base x Tax Rate, where the Tax Base = f(Tax Rate) Tax Rate 0% 20% 40% 60% 80% 100% Tax Base $100 $90 $70 $30 $10 $0 Tax Revenue Tax Revenue Tax Rate © 2010 Jane Himarios, Ph.D. Example 2: Tax Revenue B A C 4.96% Philadelphia Payroll Tax Rate When Philadelphia cut its payroll tax rate by 8% (in the late 1990s, early 2000s), its tax revenue rose by 19%. © 2010 Jane Himarios, Ph.D. Supply Side Economics Worksheet Keynesians believe that there is a trade-off between the inflation rate and the unemployment rate. If they want to reduce the unemployment rate they will have to settle for a higher inflation rate, and vice versa. An economist named Milton Friedman said that there is no such trade-off, and predicted that you could see higher unemployment rates associated with higher inflation rates. Use this AD-SRAS curve diagram to show how this could happen (that is, show stagflation): LRAS SRAS AD Now add a curve to this diagram to show the supply-side solution to stagflation. What tool do supply-side theorists advocate using to accomplish the shift you have shown? _____________________________ Ronald Reagan’s platform promises: 1. (Circle the change that he promised) Raise/lower marginal income tax rates 2. (Circle the change that he promised) Raise/lower real GDP 3. (Circle the change that he promised) Raise/lower unemployment rates 4. (Circle the change that he promised) Raise/lower inflation rates 5. (Circle the change that he promised) Raise/lower the budget deficit 6. (Circle the change that he promised) Raise/lower the growth rate Explain how lower marginal income tax rates can lead to smaller budget deficits: Is there any real-world evidence that lower marginal income tax rates have led to increases in tax revenue? Explain your answer. © 2010 Jane Himarios, Ph.D. Methods #7 and #8 for shifting LRAS: 7. Cutting marginal business tax rates to increase investment by firms 8. Reducing regulations to increase investment by firms IV. Implementing Fiscal Policy A. Automatic Stabilizers Reduce the Intensity of Business Cycle Fluctuations When the economy is growing, tax revenue rises and transfer payments falls, mitigating the growth and reducing the possibility of inflation. When the economy is shrinking, tax revenue falls and transfer payments rise, mitigating the contraction and reducing the possibility of a recession. B. Fiscal Policy Timing Lags By the time the stimulus has an impact, the economic problem it was designed to solve (1) may no longer exist, (2) may not exist to the degree it once did, or (3) may have changed altogether. If this is the case, the stimulus may hurt rather than help. 1. Data lag 2. Recognition lag 3. Implementation lag © 2010 Jane Himarios, Ph.D. C. Crowding Out Effect Borrowing to finance a deficit drives up interest rates causing consumption and investment spending to fall. This reduces the effectiveness of the stimulus. Preliminary information before we continue: Interest rates are determined in the loanable funds market The price of borrowing (the interest rate) is set by market forces and depends on the demand for loans and the supply of loans. The price of borrowing Supply of loans funds is the interest rate r* Q* Demand for loans Loanable Funds If : The demand for loans increases The demand for loans decreases The supply of loans increases The supply of loans decreases Then the interest rate will: If the interest rate: Then consumption spending and investment spending will: Rises Falls © 2010 Jane Himarios, Ph.D. Crowding Out Exercises As we work through these in-class exercises, you will learn how crowding out effects diminish fiscal policy effectiveness. Exercise #1: This exercise shows us what happens in the absence of government intervention Participants: A banker, three individuals who want consumer loans and two individuals who want business loans. In this exercise the banker makes loans to these five individuals. These five individuals will spend this money. Notice how much money they will spend. Exercise #2: The first crowding out effect occurs when financing the federal deficit drives up interest rates causing consumption and investment spending to fall Participants: A banker, three individuals who want consumer loans, two individuals who want business loans, and Uncle Sam, who wants to borrow money in order to finance deficit spending. Answer these questions: 1. What effect will Uncle Sam’s spending have on the AD curve? 2. What effect will Uncle Sam’s borrowing have on the interest rate? 3. What effect will the interest rate change have on consumption and investment spending? (Notice that consumers and firms spend less in this exercise than they did in exercise #1.) 4. What effect will the change in consumption and investment spending have on the AD curve? 5. What causes the crowding out effect in this exercise?