Download Chapter 15: Fiscal Policy Learning Goals

Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
Chapter 15: Fiscal Policy
Learning Goals:
ƒ Describe the federal budget process and the recent history of
expenditures, taxes, deficits, and debt
ƒ Examine the supply-side effects of fiscal policy on employment and
potential GDP
ƒ Explain how fiscal policy choices redistribute benefits and costs across
generations
ƒ Explain how fiscal policy can be used to stabilize the business cycle
I. The Federal Budget
A. The federal budget is the annual statement of the U.S. federal government’s
expenditures and tax revenues together with the laws and regulations that
approve and support those expenditures.
Fiscal policy is the use of the federal budget to achieve macroeconomic
objectives such as full employment, sustained economic growth, and price level
stability.
B. The Institutions and Laws
1. Fiscal policy is made by the president and Congress. Figure 15.1 illustrates
the timeline.
2. Fiscal policy operates within the framework of the Employment Act of 1946,
which committed the government to work “to promote maximum
employment, production, and purchasing power.”
3. The President’s Council of Economic Advisers monitors the economy and
keeps the President and the public well informed about the current state of
the economy and the best available forecast of where it is heading.
C. Highlights of the 2004 Budget
1. Tax revenues come from personal income taxes, social security taxes,
corporate income taxes, and indirect taxes. Personal income taxes followed
by social security taxes are the two largest revenue sources.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
2. Expenditures are classified as transfer payments, purchases of goods and
services, and debt interest. Transfer payments are by far the largest
expenditure, and are sources of persistent growth in expenditures.
3. The federal government’s budget balance equals tax revenues minus
expenditures.
a) If tax revenues exceed expenditures, the government has a budget
surplus.
b) If expenditures exceed tax revenues, the government has a budget
deficit.
c) If tax revenues equal expenditures, the government has a balanced
budget.
D. The Budget in Historical Perspective
1. Figure 15.2 shows the government’s tax revenues, expenditures, and budget
surplus or deficit as a percentage of GDP for the period 1980–2004.
2. Figure 15.3 shows the evolution of the components of tax revenues and
expenditures as a percentage of GDP over the period 1980–2004.
3. Government debt is the total amount that the government has borrowed. It
is the sum of past budget deficits minus past budget surpluses.
4. The debt to GDP ratio reached a peak at the end of World War II in 1945. It
then generally fell until 1974. From 1974 to 1992 the ratio rose; it then fell
from 1992 to 2002, when it started to increase again.
E. The U.S. Government Budget in Global Perspective
1. Figure 15.5 compares government budget deficits around the world in 2003.
2. The world as a whole that year had a government budget deficit of about 3.1
percent of world GDP.
F. State and Local Budgets
1. In 2002, when the federal government spent $2,000 billion, state and local
governments spent about $1,900 billion, mostly on education, protective
services, and roads.
2. State and local budgets are not used for stabilization purposes, and
occasionally are destabilizing in recessions.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
II. The Supply Side: Employment and Potential GDP
A. The effects of fiscal policy on employment, potential GDP, and aggregate
supply are known as supply-side effects.
B. Full Employment and Potential GDP
1. At full employment, the real wage rate adjusts to make the quantity of labor
demanded equal the quantity of labor supplied. Potential GDP depends on
the full-employment quantity of labor.
C. The Effects of the Income Tax on Aggregate Supply
1. By reducing the take-home wage of workers, the income tax lowers the
supply of labor (see graph on next page).
2. The gap between the before-tax and after-tax wage rates is like a wedge and
is called the tax wedge.
3. The decrease in labor supply raises the real wage rate paid by firms and
lowers the full-employment quantity of labor.
4. The decrease in the full-employment quantity of labor decreases potential
GDP and aggregate supply.
Graph of the Labor Market and the Impact of a Tax Cut
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
D. Taxes on Expenditure and the Tax Wedge
1. Taxes on consumption expenditure add to the wedge by raising the prices
paid for consumption goods and services, which is equivalent to a cut in the
real wage rate.
E. Some Real World Tax Wedges
1. Figure 15.7 displays estimated tax wedges in three industrial countries.
F. Does the Tax Wedge Matter?
1. According to Edward Prescott, an economist at the University of Minnesota,
the entire difference in potential GDP between France and the United States
can be attributed to the difference in the tax wedge in the two countries,
while about a third of the difference in potential GDP between the United
Kingdom and the United States arises from the difference in the tax wedge in
the two countries.
G. Tax Revenues and the Laffer Curve
1. The relationship between the tax rate and the amount of tax revenue
collected is called the Laffer curve.
2. The figure below illustrates the Laffer curve. As the tax rate increases, tax
revenues initially increase. But above a certain level, an increase in the tax
rate causes tax revenues to fall.
Graph of the Laffer Curve
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
H. The Supply-Side Debate
1. In the Reagan administration, supply-siders believed the U.S. economy
was on the right-hand portion of the Laffer curve and predicted that tax
revenues would increase when tax rates were cut. In reality, tax revenues
fell and the deficit increased when the Reagan administration cut tax
rates.
2. However, most economists recognize that tax rates have some impact on
labor supply and potential GDP.
The Supply Side: Investment, Saving, and Economic Growth
Skip this section from your book.
III. Generational Effects of Fiscal Policy
A. Generational accounting is an accounting system that measures the
lifetime tax burden and benefits of each generation.
B. Generational Accounting and Present Value
1. A present value is an amount of money that, if invested today, will grow
to equal a given future amount when the interest that it earns is taken into
account.
2. Because there is uncertainty about the proper interest rate to use when
calculating present values, plausible alternative numbers are used to
estimate a range of present values.
C. The Social Security Time Bomb
1. Fiscal imbalance is the present value of the government’s commitments
to pay benefits minus the present value of its tax revenues. In 2003, the
fiscal balance was estimated to be $45 trillion.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
2. There are four alternatives available to address the fiscal imbalance:
a) Raise income taxes.
b) Raise social security taxes.
c) Cut social security benefits.
d) Cut federal government discretionary spending.
D. Generational Imbalance
1. Generational imbalance is the division of the fiscal imbalance between
the current and future generations, assuming that the current generation
will enjoy the current levels of taxes and benefits.
2. Figure 15.12 shows an estimate of how today’s fiscal imbalance is
distributed across the current and future generations.
a) It is estimated that the current generation will pay 43 percent of the
fiscal imbalance and future generations will pay 57 percent.
b) The major source of generational imbalance is Medicare.
E. International Debt
1. A large amount of U.S. investment and government expenditures have
been financed by borrowing from the rest of the world.
2. At the end of June 2003, the United States had a net debt to the rest of
the world of $4 trillion, $2.1 trillion of which is U.S. government securities.
IV. Stabilizing the Business Cycle
A. Discretionary fiscal policy is a policy action that is initiated by an act of
Congress. Automatic fiscal policy is a change in fiscal policy triggered by
the state of the economy.
B. The Government Purchases Multiplier
1. The government purchases multiplier is the magnification effect of a
change in government purchases of goods and services on aggregate
demand.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
2. A multiplier exists because government purchases are a component of
aggregate expenditure; an increase in government purchases increases
aggregate income, which induces additional consumption expenditure.
3. For example, the increase in security expenditures by the federal
government following the terrorist attacks of September 11, 2001
generated a multiplier effect as better off security workers increased their
consumption expenditures.
C. The Tax Multiplier
1. The tax multiplier is the magnification effect a change in taxes on
aggregate demand.
2. A decrease in taxes increases disposable income, which increases
consumption expenditure and increases aggregate expenditure and real
GDP.
3. The amount by which a tax increase lowers consumption expenditure is
determined by the marginal propensity to consume. For example, if the
marginal propensity to consume is 0.75, a $1 tax cut increases
consumption expenditure by only 75 cents. In this case, the tax multiplier
is 0.75 times the magnitude of the government purchases multiplier.
4. Congress enacted the Bush tax cut package that lowered taxes starting in
2002. These tax cuts had a multiplier effect as higher disposable income
led to higher consumption expenditure.
D. The Balanced Budget Multiplier
1. The balanced budget multiplier is the magnification effect on aggregate
demand of a simultaneous change in government purchases and taxes
that leaves the budget balance unchanged.
2. The balanced budget multiplier is positive because a $1 increase in
government purchases increases aggregate demand by more than a $1
increase in taxes decreases aggregate demand.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
E. Discretionary Fiscal Stabilization
1. If real GDP is below potential GDP, the government might increase its
purchases of goods and services, cut taxes, or do some of both to
increase aggregate demand.
a) These policies are expansionary policies that can be used to eliminate
a recessionary gap.
b) The figure below shows the effect of an expansionary fiscal policy.
2. Similarly, if real GDP is above potential GDP, the government might
decrease its purchases of goods and services, raise taxes, or do some of
both to decrease aggregate demand.
a) These policies are contractionary policies that can be used to eliminate
an inflationary recessionary gap.
b) The figure below shows the effect of a contractionary fiscal policy.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
F. Limitations of Discretionary Fiscal Policy
1. In practice, fiscal policy is hampered by time lags:
a) There is a recognition lag because of the time it takes to figure out that
fiscal policy actions are needed.
b) There is a law-making lag because of the time it takes Congress to
pass the laws needed to change taxes or spending.
c) There is a impact lag because of the time it takes for a change in the
law to impact real GDP.
G. Automatic Stabilizers
1. Automatic stabilizers are mechanisms that stabilize real GDP without
explicit action by the government. Tax revenues and expenditures that
fluctuate with real GDP are automatic stabilizers.
2. Taxes that vary with real GDP are called induced taxes.
3. Government expenditure on programs that pay benefits to people and
businesses depending on their economic status is called needs-tested
spending.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2005
4. Because induced taxes and needs-tested spending change with the
business cycle, the government’s budget deficit also varies with this
cycle. In a recession, taxes fall, spending rises, and the deficit grows; in
an expansion, taxes rise, spending falls, and the deficit shrinks.
5. Figure 15.15 shows the budget deficit over the business cycle for 1983–
2003.
6. The structural surplus or deficit is the surplus or deficit that would
occur if the economy were at full employment and real GDP were equal
to potential GDP. The cyclical surplus or deficit is the actual surplus or
deficit minus the structural surplus or deficit; that is, it is the surplus or
deficit that occurs purely because real GDP does not equal potential
GDP. Figure 15.16 illustrates these ideas.
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