Download Fiscal Policy CHAPTERCHECKLIST

Fiscal Policy
CHAPTER
16
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Describe the federal budget process and the recent
history of revenues, outlays, deficits, and debts.
2
Explain the supply-side effects of fiscal policy on
employment and potential GDP.
3
Explain the demand-side effects of fiscal policy on
employment and real GDP.
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16.1 THE FEDERAL BUDGET
The federal budget is an annual statement of the
revenues, outlays, and surplus or deficit of the
government of the United States.
The federal budget has two purposes:
1. To finance the activities of the federal government
2. To achieve macroeconomic objectives
Fiscal policy is the use of the federal budget to achieve
the macroeconomic objectives of high and sustained
economic growth and full employment.
16.1 THE FEDERAL BUDGET
The Institutions and Laws
The President and the
Congress make the
budget and develop fiscal
policy on a fixed annual
time line and fiscal year.
Fiscal year is a year that
begins on October 1 and
ends on September 30.
Fiscal year 2008 begins
in 2007.
16.1 THE FEDERAL BUDGET
Budget Surplus or Budget Deficit
Budget surplus (+)/deficit (–) = Tax revenues – Outlays
The government has a budget surplus when tax
revenues exceed outlays.
The government has a budget deficit when outlays
exceed tax revenues.
The government has a balanced budget when tax
revenues equal outlays.
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16.1 THE FEDERAL BUDGET
Surplus, Deficit, and Debt
The government borrows to finance a budget deficit
and repays its debt when it has a budget surplus.
The amount of debt outstanding that arises from past
budget deficits is called national debt.
Debt at end of 2008 = Debt at end of 2007 + Budget
deficit in 2008.
16.1 THE FEDERAL BUDGET
The Federal Budget 2008
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Fiscal policy has important effects on potential GDP and
aggregate supply.
Supply-side effects are the effects of fiscal policy
on potential GDP.
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16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Fiscal Policy and Potential GDP
Both sides of the government's budget influences
potential GDP.
The expenditure side provides public goods and
services that enhance productivity.
The increase in productivity increases potential GDP.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
On the revenue side, taxes modify incentives and
change the equilibrium in the labor market and capital
markets.
An increase in taxes drives a wedge between the cost
of labor to employers and the take-home pay of
workers.
Tax wedge in the labor market is the gap between
the before-tax wage rate and the after-tax wage rate.
The result is a decrease in the equilibrium quantity of
labor employed and a decrease in potential GDP.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Fiscal Policy and Potential GDP: A Graphical
Analysis
Full Employment with
No Income Tax
The wage rate is $30 an
hour and 250 billion hours
of labor is employed.
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16.2 THE SUPPLY SIDE AND POTENTIAL GDP
The economy is at full
employment with 250
billion hours of labor
employed.
The production function
shows that when 250
billion hours are employed,
potential GDP is $11
trillion.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
The Effects of the Income
Tax
The income tax
1. Decreases the supply of
labor.
2. Creates a tax wedge
between the wage rate
that firms pay and workers
receive.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
3. The before-tax wage rate
rises to $35 an hour.
4. The after-tax wage rate
falls to $20 an hour.
5. Full employment
decreases to 200 billion
hours.
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16.2 THE SUPPLY SIDE AND POTENTIAL GDP
5. Full employment
decreases to 200 billion
hours.
6. Potential GDP decreases
to $10 trillion.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Taxes on Expenditure and the Tax Wedge
Taxes on consumption expenditure add to the tax wedge that
lowers potential GDP.
The reason is that a tax on consumption expenditure raises the
prices paid for consumption goods and services and is equivalent
to a cut in the real wage rate.
To find the total tax wedge, add the expenditure tax rate to the
income tax rate.
For example, if the income tax rate is 25 percent and the
expenditure tax is 10 percent, the tax wedge is 35 percent.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Taxes, Deficits, and Economic Growth
Fiscal policy influences economic growth in two ways:
1. Taxes drive a wedge between the interest rate paid
by borrowers and the interest rate received by
lenders.
2. If there is a budget deficit, government borrowing to
finance the deficit competes with firms’ borrowing to
finance investment and to some degree, government
borrowing “crowds out” private investment.
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16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Interest Rate Tax Wedge
Lenders pay an income tax on the interest they receive
from borrowers, which creates an interest rate tax
wedge.
A tax on interest lowers the quantity of saving and
investment and slows the growth rate of real GDP.
A tax on interest income creates a Lucas wedge—an
ever widening gap between potential GDP and the
potential GDP that might have been.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Investment and saving plans depend on the real aftertax interest rate.
The real interest rate equals the nominal interest rate
minus the inflation rate.
So the after-tax interest rate equals the real interest rate
minus the income tax paid on interest income.
But the nominal interest rate, not the real interest rate,
determines the amount of tax to be paid; and the higher
the inflation rate, the higher is the nominal interest rate,
and the higher is the true tax rate on interest income.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Deficits and Crowding Out
A tax cut that increases the budget deficit brings a
decrease in the supply of loanable funds to firms.
The interest rate rises and crowds out private investment.
But the lower income tax rate shrinks the tax wedge and
stimulates employment, saving, and investment.
But a higher budget deficit lowers investment.
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16.2 THE SUPPLY SIDE AND POTENTIAL GDP
Income Tax Revenues and the Laffer Curve
Laffer curve is the relationship between the tax rate
and total tax revenue. As the tax rate rises, tax revenues
rise, reach a maximum, and then fall.
Figure 16.3 on the next slide illustrates the Laffer curve.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
1. At a tax of t*, tax revenue
is maximized.
2. For tax rates below t*, an
increase in the tax rate
increases tax revenue.
For example, the United
States and United kingdom.
3. For tax rates above t*, an
increase in the tax rate
decreases tax revenue.
Perhaps France is an
example.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Two Types of Fiscal Stabilizer
Fiscal policy action that are aimed at stabilizing
aggregate demand can be
• Discretionary fiscal policy
• Automatic fiscal policy
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16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Discretionary fiscal policy is a fiscal policy action
that is initiated by an act of Congress.
For example, an increase in defense spending or a cut
in the income tax rate.
Automatic fiscal policy is a fiscal policy action that
is triggered by the state of the economy.
For example, an increase in unemployment induces an
increase in payments to the unemployed or in a
recession tax receipts decrease as incomes fall.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Discretionary Fiscal Policy Multipliers
The government expenditure multiplier is the
magnification effect of a change in government
expenditure on goods and services on aggregate
demand.
An increase in aggregate expenditure increases
aggregate demand, which increases real GDP.
The increase in real GDP induces an increase in
consumption expenditure, which further increases
aggregate demand.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
The Tax Multiplier
The tax multiplier is the magnification effect of a
change in taxes on aggregate demand.
A decrease in taxes increases disposable income.
The increase in disposable income increases
consumption expenditure and aggregate demand.
With increased aggregate demand, employment and
real GDP increase and consumption expenditure
increases yet further.
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16.3 THE DEMAND SIDE: STABILIZING REAL GDP
So a decrease in taxes works like an increase in
government expenditure.
Both actions increase aggregate demand and have a
multiplier effect.
The magnitude of the tax multiplier is smaller than the
government expenditure multiplier.
The reason: A $1 tax cut increases aggregate
expenditure by less than $1 whereas a $1 increase in
government expenditure increases aggregate
expenditure by $1.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
The Transfer Payments Multiplier
The transfer payments multiplier is the
magnification effect of a change in transfer payments on
aggregate demand.
This multiplier works like the tax multiplier but in the
opposite direction.
An increase in transfer payments increases disposable
income, which increases consumption expenditure.
With increased consumption expenditure, employment
and real GDP increase and consumption expenditure
increases yet further.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
The Balanced Budget Multiplier
The balanced budget multiplier is the magnification
effect on aggregate demand of a simultaneous change
in government expenditure and taxes that leaves the
budget balance unchanged.
The balanced budget multiplier is not zero—it is
positive—because the government expenditure
multiplier is larger than the tax multiplier.
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16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Expansionary Fiscal Policy
If real GDP is below potential GDP, the government
might use an expansionary fiscal policy in an attempt to
restore full employment.
Expansionary fiscal policy is a discretionary fiscal
policy designed to increase aggregate demand—a
discretionary increase in government expenditure or
transfer payment or a discretionary tax cut.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Figure 16.4 illustrates an
expansionary fiscal policy.
Potential GDP is $10 trillion,
real GDP is $9 trillion, and
1. There is a $1 trillion
recessionary gap.
2. An increase in government
expenditure or a tax cut
increases expenditure by ∆E.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
3. The multiplier increases
induced expenditure. The
AD curve shifts rightward to
AD1.
The price level rises to 110,
real GDP increases to $10
trillion, and the recessionary
gap is eliminated.
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16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Contractionary Fiscal Policy
If real GDP is above potential GDP, the government
might use an contractionary fiscal policy in an attempt to
restore full employment.
Contractionary fiscal policy is a discretionary fiscal
policy designed to decrease aggregate demand—a
decrease in government expenditure, a decrease in
transfer payment, or a tax increase.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Figure 16.5 illustrates
contractionary fiscal policy.
Potential GDP is $10 trillion,
real GDP is $11 trillion, and
1. There is a $1 trillion
inflationary gap.
2. A decrease in government
expenditure or a tax rise
decreases expenditure by ∆E.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
3. The multiplier decreases
induced expenditure.
The AD curve shifts
leftward to AD1.
The price level falls to 110,
real GDP decreases to
$10 trillion, and the
inflationary gap is
eliminated.
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16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Combined Demand-Side and Supply-Side
Effects
An increase in government expenditure or a tax cut
increases equilibrium real GDP but might raise, lower,
or have no effect on the price level.
Figure 16.6 on the next slides shows the combined
effects of fiscal policy when fiscal policy has no effect
on the price level.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
1. A tax cut increases disposable
income, which increases
aggregate demand from AD0
to AD1.
A tax cut also strengthens the
incentive to work, save, and
invest, which increases
aggregate supply from AS0 to
AS1.
2. Real GDP increases.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Limitations of Discretionary Fiscal Policy
The use of discretionary fiscal policy is seriously
hampered by four factors:
• Law-making time lag
• Shrinking area of law-maker discretion
• Estimating potential GDP
• Economic forecasting
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16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Law-Making Time Lag
The amount of time it takes Congress to pass the laws
needed to change taxes or spending.
This process takes time because each member of
Congress has a different idea about what is the best tax
or spending program to change, so long debates and
committee meetings are needed to reconcile conflicting
views.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Shrinking Area of Law-Maker Discretion
Expenditure on the military and on homeland security and
very large expansion in expenditure on entitlement
programs such as Medicare has increased.
The result is that around 80 percent of the federal budget
is effectively off limits for discretionary fiscal policy action.
The 20 percent that is available for discretionary change
include items such as education and the space program,
which are very hard to cut.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Estimating Potential GDP
It is not easy to tell whether real GDP is below, above,
or at potential GDP.
So a discretionary fiscal action might move real GDP
away from potential GDP instead of toward it.
This problem is a serious one because too much fiscal
stimulation brings inflation and too little might bring
recession.
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16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Economic Forecasting
Fiscal policy changes take a long time to enact in
Congress and yet more time to become effective.
So fiscal policy must target forecasts of where the
economy will be in the future.
Economic forecasting has improved enormously in
recent years, but it remains inexact and subject to error.
So for a second reason, discretionary fiscal action might
move real GDP away from potential GDP and create
the very problems it seeks to correct.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Automatic Fiscal Policy
A consequence of tax receipts and expenditures that
fluctuate with real GDP.
Automatic stabilizers are features of fiscal policy
that stabilize real GDP without explicit action by the
government.
Induced Taxes
Induced taxes are taxes that vary with real GDP.
16.3 THE DEMAND SIDE: STABILIZING REAL GDP
Needs-Tested Spending
Needs-tested spending is spending on programs
that entitle suitably qualified people and businesses to
receive benefits— benefits that vary with need and with
the state of the economy.
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