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© 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?