Download Fiscal Policy

The Federal Budget
and Fiscal Policy
Ch 5: pg 84-87
Ch 12: All
Ch 18: Pg 342-350
Ch 31: pg 618 - 620
Chap 5, 12, 31 Vocabulary
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Spillover costs
Spillover benefits
Transfer payments
Personal income tax
Payroll taxes
Corporate income tax
Fiscal policy
Crowding out effect
Supply side fiscal
policy
Employment Act of
1946
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Expansionary fiscal
policy
Contractionary fiscal
policy
Built in stabilizers
Budget deficit
Budget surplus
Progressive tax
system
Political business cycle
Public Debt
U.S. Securities
A Look at the Debt
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http://www.usdebtclock.org/
These chapters will explain how we
got a debt, why it continues to grow,
and what are some of the effects.
The American Way of Debt
Why do we have a Deficit?
Structural
Debt (the
government
spends more
than it takes
in
5
Government Spending and Tax Revenue for Some
High-Income Countries in 2006
FISCAL POLICY
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These chapters study how governments
can use fiscal policy(or changes in
taxes and government spending) to
affect the level of GDP in order to stabilize
the economy (to achieve particular
economic goals, such as low
unemployment, price stability, and
economic growth.)
In later chapters we will evaluate
monetary policy (concerned with the
money supply and interest rates). You
MUST be able to distinguish between
Fiscal and Monetary policy.
The Federal Budget
(Chap 5 pg 84-87)
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The federal budget—the actual document that
describes what the federal government spends
and how it pays for it— it provides the
framework for fiscal policy. The last time
congress passed a budget was in 2009. We
now fund the government as it is needed (why
we have issues like sequestration, or
emergency funding bills in Congress).
In 2003, total federal spending approximately
was 19.9 percent of GDP, or $2.15 trillion.
Federal taxes were 16.5 percent of GDP.
The government runs its budget on a fiscal
year basis, from October 1 to September 30.
Federal Spending for Fiscal Year 2003
Category
Total outlays
Discretionary spending
Outlays
(billions)
% of
Budget
$2,158
825
38
405
420
19
19
1,179
55
Medicare and Medicaid
470
535
22
25
Other programs
174
8
153
7
Defense
Non-Defense
Entitlements and
mandatory spending
Social Security
Net interest (also
mandatory spending)
Federal Spending
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Discretionary spending
constitutes all the programs that
Congress authorizes on an annual
basis, which are not automatically
funded by prior laws passed by
Congress. This constitutes
approximately 38% of the total
budget (50% of this 38% is defense
spending.
Mandatory (Entitlement)
spending constitutes all spending
that Congress authorized by prior
laws. This is the single largest
component of the federal budget.
Federal Spending (Continued)
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Examples of mandatory spending
(entitlement programs):
• Social security provides
retirement payments to retirees, as
well as a host of other benefits to
widows and families of disabled
workers.
• Medicare provides health care to
all individuals once they reach the
age of 65.
• Medicaid provides health care to
the poor, in conjunction with the
states.
Sources of Federal Government Revenue,
Fiscal Year 2003
Category
Receipts
% of
(billions)
revenues
Total revenue
$1,720
Individual income taxes
794
45
Social insurance taxes
713
40
22
1
132
7
Excise taxes and customs
duties
87
5
Miscellaneous receipts
34
2
Estate and gift taxes
Corporate income taxes
Federal Revenues
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The single largest component of federal
revenue are individual income taxes.
During the year, the federal government
collects some of the taxes due in advance
by withholding a portion of workers’
paychecks.
The second largest component of federal
revenue are social insurance taxes
(FICA) which are taxes levied on earnings
to pay for Social Security and Medicare.
Another tax paid directly by individuals
and families are estate and gift taxes.
Federal Revenues (Continued)
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The corporate tax is a tax levied on the
earnings of corporations. This tax raised
less than 7.5% of total federal revenues
during fiscal year 2003.
The other sources of government revenue
are relatively minor. Federal excise
taxes are taxes levied on the sale of
some products, e.g. like gasoline, tires,
firearms, alcohol and tobacco. Custom
duties are taxes levied on goods
imported to the United States such as
foreign cars or wines.
The budget deficit as a percentage of GDP tends
to rise during recessions (indicated by shaded
areas) and fall during expansions.
The budget deficit as a percentage of GDP moves
closely in tandem with the unemployment rate.
Stability Pact—or ?
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In 1999 a group of European nations adopted a
common currency, the euro, to replace their national
currencies.
Governments of member countries signed on to the
European “stability pact.” This agreement required
each government to keep its budget deficit below 3%
of the country’s GDP or face fines. The stability pact,
however, limited a country’s ability to use fiscal
policy.
In 2002 both France and Germany were experiencing
rising unemployment and also running budget deficits
in excess of 3% of GDP.
In March 2005 the stability pact was rewritten to allow
“small and temporary” breaches of the 3% limit.
In 2003
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Government Spending was:
• $2,158 Billion
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Government Revenues were:
• $1,720 Billion
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Or in other words, the government
spent about $438 million more than
it took in (or a deficit of $438 million
which was added to the debt)
In 2011
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Government Spending was:
• $3.8 Trillion
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Government Revenues were:
• $2.6 Trillion
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The deficit was:
• -$1.3 Trillion
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The total debt was: $14+ Trillion
Budget and Debt
• See section 7 and 15 of document
Types of Taxes
Pg 618 - 620
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Progressive Tax: the tax rate
increases as a person’s taxable
income level rises. A progressive tax
is usually capped at some tax rate.
The income tax in the U.S. is a
progressive tax.
Proportionate Tax: the same tax
rate is used for all levels. This is
sometimes called a flat tax; e.g.
property taxes
Regressive Tax: the tax rate
decreases as a person’s taxable
income level rises; e.g. a sales tax
Chapter 12
EMPLOYMENT ACT OF 1946
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GAVE GOVERNMENT THE POWER TO
STABILIZE THE ECONOMY
•
•
•
•
PROMOTE ECONOMIC GROWTH
REDUCE UNEMPLOYMENT
CONTROL PRICES
CREATED THE PRESIDENT’S COUNCIL OF
ECONOMIC ADVISORS
Fiscal Policy
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Government efforts to promote full
employment and price stability by
changing government spending (G)
and/or taxes (T).
Recession is countered with
expansionary policy.
)
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• Increase government spending (G
• Decrease taxes (T )
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Inflation is countered with
contractionary policy
)
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• Decrease government spending (G
• Increase Taxes (T )
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“Keynesian” Fiscal Policy (or
“Obamanomics” - really)
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Keynesian economic theory was developed in the 1930s
and suggests that governments need to intervene in the
economy to end or minimize recessions or slow growth
if inflation should occur. John Maynard Keynes
supported active Fiscal Policy. The recent
bailout/stimulus package by the government is an
excellent example of Keynesian Economics.
A change in consumption, investment, government
purchases, or net exports can change aggregate
demand and therefore shift the aggregate Demand (AD)
curve.
A change in taxes can affect consumption or investment
or both and therefore can affect AD.
Investment Tax Credits
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An investment tax credit is a tax break given to firms
based on their investment spending. This increases the
incentive for investment spending.
Investment tax credits are often temporary, applying
only to investment spending within a specific period.
Like department store sales that encourage shoppers to
spend a lot while the sale is on, temporary investment
tax credits tend to generate a lot of investment spending
when they’re in effect. Even if a firm doesn’t think it will
need a new computer server or lathe for another year or
so, it may make sense to buy it while the tax credit is
available, rather than wait.
Investment Tax Credits were extensively used to end the
March 2001 Recession. Business were able to deduct an
entire technology purchase in “one” year rather than
spread the purchase out over several tax years.
TYPES OF DISCRETIONARY
FISCAL POLICIES
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Expansionary Fiscal Policy: Increases in
government expenditures and/or decreases in
taxes to achieve particular economic goals.
The purpose of this policy would be to cause an
increase in aggregate demand. Typically
consumers have more money and the dollar
depreciates. Exports increase and imports
decrease.
Contractionary Fiscal Policy: Decreases in
government expenditures and/or increases in
taxes to achieve macroeconomic goals. This
policy is implemented to decrease aggregate
demand. Amount of money in circulation
declines and dollar appreciates; exports
decline, imports increase
Contractionary Fiscal Policies
(to counter Demand Pull Inflation)
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Decrease government spending
• Intended to halt further price increases
or inflation
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Increase taxes
• to slow consumption and business
spending
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Budget moves toward a surplus
Contractionary Fiscal Policy
(to counter Inflation)
LRAS
PL
SRAS
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P

P1
AD
AD1

YF
Y
This AD/AS
graph
represents
an economy
exceeding
full
employment
and
experiencing
inflation.
GDPR
A decrease in G or an increase in T causes AD to decrease from
AD to AD1 and causes employment to return to Full Employment
And reduces inflation.
Expansionary Fiscal Policies (to
counter a slowing economy)
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Increase Government Spending
• Effect depends upon the “Multiplier”
• The “balanced-budget multiplier” states
that G increase/decrease equal to a similar
change in T = a multiplier of 1
Tax Cuts
Government spending is MORE expansionary
than tax cuts due to the effects of the MPC
(Remember the 2008 Tax Rebates – we spent
$20 billion of the $80 billion tax rebates. The
government could have spent the entire $80
billion to stimulate the economy.
Budget moves toward a deficit
Expansionary Fiscal Policy in Japan
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Japan turned to expansionary fiscal policy in the
early 1990s.
At the end of the 1980s Japan’s bubble burst—
stock and land values plunged.
During the years that followed, Japan relied on
large-scale government purchases of goods and
services, mainly in the form of construction
spending on infrastructure, to prop up aggregate
demand.
This spending was scaled back after 2000, but at
its peak it was truly impressive. In 1996 Japan
spent about $300 billion on infrastructure.
Expansionary Fiscal Policy in Japan
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Was this policy a success? Yes and no.
Many economists believe that without all that
government spending, the Japanese economy
would have slid into a 1930s-type depression
after the bursting of the bubble economy.
Instead, the economy suffered a slowdown but
not a severe slump.
The most recent recession in the U.S. is a very
close parallel to the situation in Japan in the 90s.
About That Stimulus Package . . .
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In early 2008 there was broad bipartisan agreement
that the U.S. economy needed a fiscal stimulus. There
was, however, sharp partisan disagreement about
what form that stimulus should take.
Republicans favored tax cuts on general political
principles. Democrats, by contrast, preferred transfer
payments, especially increased unemployment
benefits and expanded food stamp aid.
The eventual compromise gave most taxpayers a flat
$600 rebate, $1,200 for married couples. How well
designed was the stimulus plan?
Many economists believed that only a fraction of the
rebate checks would actually be spent, so that the
eventual multiplier would be fairly low.
Differences in the Effect of Expansionary Fiscal
Policies
Is Deficit Spending Good or Bad?
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Republicans would like to cut taxes and reduce
government spending.
• Tax rates in the U.S. are at the lowest levels since the
50s and the U.S. has one of the lowest tax rates of any
Industrialized country.
• How should we bring government spending under
control
• Denmark and Germany have some of the highest growth
rates but also have some of the highest tax rates.
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China, South Korea, Germany, and Canada have all
used government intervention to promote job growth.
In the 50s, 60s, and 70s, the U.S. invested heavily in
infrastructure promoting job growth.
How will the health care plan affect the economy?
Will it boost growth; reduce growth; extend life
expectancy???
Expansionary Fiscal Policy
LRAS
PL
SRAS
This AD/AS
graph
represents a
recession (less
than full
employment)

P

P1
AD1
AD

Y
YF
GDPR
Increase in G or a reduction of T causes AD to move from AD to
AD1 and restores full employment.
Non-Discretionary Fiscal Policy
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Taxes and transfer payments that stabilize
GDP without requiring explicit actions by
policymakers are called built in (or
automatic) stabilizers.
During an economic boom, transfer
payments fall, taxes increase and
government revenues increase.
During a recession, running a government
budget deficit (increasing government
spending) offsets part of the decrease in
AD thus helps stabilize the economy.
The Federal Deficit and Fiscal Policy
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The federal government runs a budget deficit
when it spends more than it receives in tax
revenues. For FY 2008 the deficit was
approximately $480 billion (this was added to the
Federal Debt). In FY 2009, the deficit was $1.8
trillion; 2010 deficit was $1.6 trillion; 2011 it is
projected to be $1.3 trillion
If the government collects more in taxes than it
spends, it will run a budget surplus. The last
years for a surplus were 1998, 1999 and 2000.
The total of all annual deficits is the Federal (or
Public) Debt. The current debt is over $14
trillion. Currently, approximately 7% of the Federal
Budget is spent paying only the interest on the
debt – the principal of the debt (the $16 trillion) is
not being paid.
Debts and Deficits
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In 2000, the public (national) debt was
$5.6 Trillion. Today it is ???
http://www.usdebtclock.org/
Debt concerns:
• Debt versus economic growth (GDP)
• Paying the interest on the debt
• Crowding out may hinder capital
development; i.e. government spending
may not improve long term economic
growth as much as investment spending.
Financing a Deficit
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To finance a deficit the government
can:
• Borrow by selling bonds

This may “crowd out” private investment
by raising interest rates. By borrowing
money, the government essentially shrinks
loanable funds and causes interest rates
to increase, thereby slowing new investment
spending. Crowding out is a disputed
economic phenomena.
• Can create “new” money. This is more
expansionary than borrowing
Loanable Funds Market
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The Loanable Funds Market is the total
money in the global economy that is
available for loans. For example, $100 in a
savings account is part of the Loanable
Funds; $100 cash in your pocket is not.
The market where savers and borrowers
exchange funds at the real rate of interest
(r%).
The demand for loanable funds, or
borrowing, comes from households, firms,
government and the foreign sector.
The supply of loanable funds, or savings,
comes from households, firms,
government and the foreign sector.
Increase in the Demand
for
Loanable
Funds
r%
SLF
r1
r
DLF
q
q1
DLF  .: r% ↑ & QLF ↑
QLF
DLF 1
Expansionary Fiscal Policy
Side-effect: ‘Crowding-out’
SLF
r%
r%
Investment
Demand Curve
ID
r1
r
DLF 1
DLF
$q
$q1
QLF
I1
I
As the interest rate rises as a result of G borrowing, the amount of
investment spending decreases in response to higher interest rates.
IG
Changes in the Demand for
Loanable Funds
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Remember that demand for loanable funds
= borrowing (i.e. selling bonds)
More borrowing = more demand for
loanable funds
Less borrowing = less demand for loanable
funds
Examples
• Government deficit spending = more borrowing
= more demand for loanable funds
As supply of funds <, the interest rates >
• Higher Interest Rates = less investment
demand = less borrowing
Final thoughts on Loanable Funds
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Loanable funds market determines the real
interest rate.
Loanable funds market relates saving and
borrowing.
Changes in saving and borrowing create
changes in loanable funds and therefore the
interest rate changes.
When government acts with fiscal policy it
will affect the loanable funds market.
Changes in the real interest rate will affect
Investment/business spending (remember:
C+I+G+(X-M) = AD
How Surpluses and Deficits Occur
Revenues
Government Expenditures,
G, and Tax Revenues, T
T
An “actual
Budget”
Surplus
Deficit
GDP1
GDP2
GDP3
Real Domestic Output, GDP
The Full
G Employment
Budget
FULL-EMPLOYMENT DEFICITS
Government Expenditures,
G, and Tax Revenues, T (billions)
Full employment budget
is represented by “G”.
$500
475
450
425
b
a
T1
G
c
GDP in year 2 has decreased resulting
in a decrease in government revenues (from $500
to $450 billion) due to increased
unemployment. An “actual budget” deficit of $50 Billio
will occur.
GDP2 GDP1
Year 2 Year 1
Real Domestic Output, GDP
FULL-EMPLOYMENT DEFICITS
Government Expenditures,
G, and Tax Revenues, T (billions)
Full employment budget
is represented by “G”.
$500
475
450
425
b
a
Tax increase
T1
Tax
Cut
G
c
You can see how the deficit is changed based
Upon and increase of decrease in the tax rate.
GDP2 GDP1
Year 2 Year 1
Real Domestic Output, GDP
Government Expenditures,
G, and Tax Revenues, T (billions)
FULL-EMPLOYMENT DEFICITS
$500
475
450
425
Discretionary Fiscal Policy
A tax decrease (T1 to T2) in
response to slowing GDP
e
f
d
h
g
T1
T2
G
As the GDP decreases (with increasing
unemployment), the government reacts
to increase aggregate demand, specifically,
consumer spending. The government
adds $25 billion to the $50 billion deficit
it will incur as a result of lowered revenues.
GDP2 GDP1
Year 2 Year 1
Real Domestic Output, GDP
FULL-EMPLOYMENT DEFICITS
Government Expenditures,
G, and Tax Revenues, T (billions)
Full employment budget
is represented by “G”.
$500
475
450
425
b
a
T1
An increase
in G
spending
G
c
GDP in year 2 has decreased resulting
in a decrease in government revenues (from $500
to $450 billion) due to increased
unemployment. An “actual budget” deficit of $50 Billio
will occur.
GDP2 GDP1
Year 2 Year 1
Real Domestic Output, GDP
EVALUATING FISCAL POLICY
Full-Employment Budget
Cyclical Deficits
Recent U.S. Deficits & Surpluses
Year
Actual
Deficit or
Surplus
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
-3.9%
-4.5
-4.7
-3.9
-2.9
-2.2
-1.4
-0.3
+0.8
+1.4
+2.4
Full-Employment
Deficit or
Surplus
-2.1%
-2.6
-3.0
-2.6
-2.0
-1.9
-1.2
-0.9
-0.4
+0.3
+1.1
How the Gov. can dispose of a
surplus

It can retire/payoff debt with the
surplus
• This might increase AD when the economy
is near a peak in the business cycle and the
increase may cause inflation.

It can impound or idle the surplus
• This action would have no effect on AD.
This is what the U.S. did with our late 90’s
surpluses and rapidly spent the surplus in
response to 9/11.
O
B
A
M
A
6
+
T
r
i
L
li
o
n
Deficit
For 2014
Was
$483 billion
Debt increased
$6.8 Trillion
Under President
Obama
Deficits and the Public Debt
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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 (domestic and
foreign banks, foreign countries, individuals,
etc.). This is the total of yearly deficits.
Who Holds the U.S. Debt?


//www.cnbc.com/id/29880401/The_
Biggest_Holders_of_US_Government
_Debt?slide=1
Current
http://www.treasury.gov/resourcecenter/data-chartcenter/tic/Documents/mfh.txt
Supply Side Fiscal Policy



Designed to increase AS (rather than
affecting AD like Keynesian approach)
According to Supply Side Economics,
lower taxes “actually” increase
government revenues and promote
growth of businesses and an increase in
Aggregate Supply. Supply Side economics
was tried during the Reagan
Administration.
Laffer Curve Fig 16.10, pg 318 is one of
the fundamental concepts of this theory.
THE LAFFER CURVE
Tax rate (percent)
100
n
m
m
Maximum
Tax
Revenue
l
0
Tax revenue (dollars)
Federal Taxes, Spending, and Deficits,
1992-2003
Problems with Fiscal Policy
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Recognition Lag: timing from the
beginning of a recession to becoming
aware of being in a recession.
Administrative Lag: time between
recognition and taking action
Operational Lag: time between passing
legislation and the implementation of that
action.
“Political Business” cycle may affect
actions; e.g. tax hikes easier after
elections and tax cuts easier during
election year.
Balanced Budget Multiplier

Remember: Government spending is
more expansionary than a tax cut;
consequently the balanced budget
multiplier says: An increase in G
equal to an increase in T will result in
an increase in the GDP.
Political Approaches

Liberal (Democrat??) Economist
• Increased Government spending to
combat a recession
• May increase the size of the
Government and affect personal
freedoms

Conservative (Republican??)
Economist
• Smaller Government; tax cuts to
combat a recession
Pg 239 Leading Indicators
How can we predict the future?

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10 variables that have historically
predicted changes in GDP
Three successive monthly decline in the
Index of Leading Economic Indicators
may forecast an impending recession;
but may also be a false warning
Some indicators are:
•
•
•
•
New orders for consumer goods
Stock prices
Consumer Confidence
Building permits
What does your (yes, you) future hold?
Future Demands on the Federal Budget