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Chapter 13. Fiscal Policy
“Americans are the most generous, kindhearted people on earth as long as they’re convinced not
one dollar of it is going for taxes.”
Will Rogers
“George Bush couldn’t answer the question when asked what the national debt meant to him
personally.”
(Neither could Bill Clinton, but he did it better.)
Objectives for Chapter 13
After reading this chapter, you should be able to:
•
•
•
•
Understand the effects of changing taxes and spending on employment and inflation.
Understand the challenges confronted and controversies in using fiscal policy.
Understand the costs and benefits of federal budget deficits, surpluses, and debt.
Make recommendations as to appropriate fiscal and monetary policies under a variety of
conditions.
Figure 13.1
MAJOR TAX CHANGES
KENNEDY/JOHNSON
1963/64 CUT
JOHNSON
LATE 60s SURCHARGE
FORD
1975 TEMPORARY REBATE
REAGAN
EARLY 80s TAX CUT
REAGAN
MID 80s TAX INCREASE
BUSH
1990 TAX INCREASE
BUSH
1991 TEMPORARY REDUCTION IN TAX
WITHHOLDING
CLINTON
EARLY 90s TAX INCREASE
CLINTON
1997 TAX CUT
BUSH
2001, 2002, and 2003 TAX CUTS
BUSH
2008 TAX REBATES AND STIMULUS PAYMENTS
OBAMA
2009, 2010, and 2011 STIMULUS PACKAGE
13-1
Why all the major tax changes listed in figure 13.1? Is it because research shows that a major
determinant of success in presidential elections is the recent condition of the economy? In fact, some
researchers have even found a business cycle in which the economy slows after a presidential election and
speeds up beginning a year before the next election.
FISCAL POLICY TOOLS
Federal government spending is criticized for wastefulness and for simply being too large. Yet think
about Social Security and the reduction of poverty among the elderly by two-thirds, the effectiveness of
the Head Start program, the creation of the internet and other technological spin-offs from defense
spending, the National Science Foundation, the Center for Disease
Fiscal policy. Most often
Control and Prevention, and the excellence of our national parks and
refers to deliberate actions by
of our military.
the federal government to
At the same time, increased taxes to pay for these programs
change taxes, spending on
reduce your and your families’ disposable incomes. You take fewer
goods and services, and
vacations, buy smaller homes, spend less on education, and save less
transfer payments with a goal
because of those higher taxes.
of influencing economic
Every year there is a debate in Washington about how much to
conditions. Also includes tax
spend, what programs to emphasize, and what to do about taxes.
and spending changes
There are few discussions in Washington that are more serious and
undertaken for other reasons.
carried on at a higher decibel level than those related to taxing and
spending. These decisions affect millions of businesses and all of us as taxpayers. But they also have
potential effects on the level of GDP, prices, our growth, and unemployment.
Let’s look. Fiscal policy is the amount and way in which government spends on goods and services
and on transfer payments and how it raises its income, that is, taxes. Often, the term “fiscal policy” is
used to mean deliberate actions by the federal government to change taxes and spending with a goal of
influencing economic conditions. But we will also look at the economic effects of tax and spending
changes that are originally contemplated for totally separate reasons.
Federal, state, and local government budgets include spending on goods and services and transfer
payments such as Social Security, welfare, Medicare, and unemployment compensation. Revenues are
almost all taxes on individuals and businesses. The largest portion of federal revenues is from income
taxes on individuals.
Using our planned spending model and our aggregate supply and demand model, let’s first calculate
the effects of an increase in spending, then changes in taxes, and then changes in transfer payments.
Changes in spending
What happens to real GDP, employment, and prices if
government spending increases? Assume we start in a long-run
equilibrium and go to a new short-run equilibrium.
Hint: Consider one change at a time.
If spending increases, it alone
increases. Taxes do not change.
If taxes change, assume that spending
stays the same.
13-2
Answer
If government increases spending on goods and services, for example, a new education
program, what will be the effect on the overall economy? In the GDP accounts, government
increases. That causes total spending to rise. Someone’s income increases and they increase
consumption spending. The effect is a larger increase in spending than the initial increase due to
the increased consumption spending. The total effect is the initial increase in spending times the
spending multiplier.
Aggregate demand increases by the multiplied amount of spending. That puts upward
pressure on prices and output begins to increase. We end up with greater real GDP, greater
employment (lower unemployment), and higher prices. (How much output increases and how
high prices go depends upon where the economy is on the aggregate supply curve.)
Changes in taxes
What happens to real GDP, employment, and prices if income taxes increase? Assume we start in a
long-run equilibrium and go to a new short-run equilibrium.
Answer
If income taxes increase, disposable income decreases. Consumers begin to decrease
consumption spending. That decrease in consumption spending has a further effect on total
spending. The ultimate effect is a larger decrease than the initial decrease due to the additional
decrease in consumption spending. The total effect is the initial decrease in consumption
spending times the spending multiplier.
Aggregate demand decreases by the multiplied amount of spending. That puts downward
pressure on prices and output begins to decrease. We end up with smaller real GDP, lower
employment (greater unemployment), and lower prices.
Changes in transfer payments
What happens to real GDP, employment, and prices if transfer payments decrease? Assume we start
in a long-run equilibrium and go to a new short-run equilibrium.
13-3
Answer
The effects of a change in transfer payments are analyzed by considering the effects on
income. The result will be very similar to a change in income taxes. A decrease in transfer
payments creates a decrease in disposable income. And the effects from there on follow the
analysis of an income tax increase.
Figure 13.2
Fiscal Policy
Government spending on goods and services
An increase will increase total spending and aggregate demand.
A decrease will decrease total spending and aggregate demand.
Income tax rates
An increase will decrease disposable income and total spending.
A decrease will increase disposable income and total spending.
Capital gains tax rates
A decrease will increase after-tax returns from investments.
Corporate profits tax rates
A decrease will give corporations more after-tax income.
Transfer payments
An increase will increase total spending.
A decrease will decrease total spending
(Increase and decreases in transfer payments work like taxes,
that is, by changing disposable income.)
13-4
Recessions and inflationary conditions
Use our models to recommend policy first if we are facing a recession or second if we are forecasting
an inflationary period.
Are our proposed policies better than letting the economy naturally solve the problem?
Answer
In a recession, the problem may be too little spending. An increase in government spending,
a decrease in income taxes, or an increase in transfer payments will cause a multiplied effect on
total spending. If done in the correct amounts, the effect would be to bring us back to full
employment.
The economy naturally returning to full employment would be superior in that it would avoid
inflation, but it may take a longer period due to the difficulty of getting wages to fall. We could
suffer an extended period of unemployment.
In an inflationary period, the problem may be too much spending. A decrease in government
spending, an increase in income taxes, or a decrease in transfer payments will cause a multiplied
decrease in total spending. If done in the correct amounts, the effect would be to bring us back to
full employment.
The economy naturally returning to full employment would be inferior in that it would work
through increased inflation. A restrictive fiscal policy would put downward pressure on prices
instead of upward pressure.
Temporary tax changes
In the list of tax cuts in figure 13.1, three were designed as temporary changes. In 1968, Lyndon
Johnson temporarily raised taxes to help reduce inflationary pressures that were largely due to increases
in government spending at a time when the economy was already producing at the full-employment level
of real GDP. Gerald Ford gave a temporary income tax rebate to stimulate the economy out of a
recession. And George Bush increased individuals’ disposable income by temporarily lowering the
amount withheld from paychecks for income taxes.
None of these efforts was nearly as successful as intended. Think back to our list of determinants of
consumption spending and explain why they were not successful.
13-5
Answer
Consumption depends upon current disposable income and future disposable income. A
temporary tax change only affects only current income. Thus, the effects of a temporary decrease
or increase would be less than if the tax changes were permanent and both future and current
income changed.
Supply shocks
In our discussion of monetary policy, we discussed policy in recessions, inflationary periods, and
supply shocks. The appropriate monetary policy was more obvious in recessions and inflationary periods
and less obvious in supply shocks. There are two choices for policy in a supply shock: (1) increase
spending, thus decreasing unemployment and increasing inflation, but inflation is already increasing, or
(2) we could decrease spending, thus increasing unemployment and reducing inflation, but unemployment
is already rising. So what do we do? The choices are not good. Part of the decision may depend upon
our interpretation of the seriousness of each problem and may be largely a value judgment.
As a generalization, labor unions, liberals, and Democrats are going to tend (but not always) to favor
reducing unemployment. Republicans, financial firms, and conservatives are going to tend (again not
always) to favor reducing inflation. But there is another way. That way is to use policy to increase
supply. The solution to both the rising unemployment and the rising inflation is to get the aggregate
supply curve to increase.
Reaganomics. On August 13, 1981, on a round, wood picnic table in front of his ranch house high
above Santa Barbara, President Ronald Reagan signed the Economic Recovery Tax Act. The bill reduced
income taxes in three annual stages: first by 10 percent, second by another 10 percent, and finally by 5
percent. The tax cuts came to be known as the core of “Reaganomics”. The purpose was to stimulate
supply, by encouraging people to work harder and to save and invest more, and thus the economy would
grow more rapidly. In a grand experiment, supply-side tax cuts were used with
a purpose not used prior to that time. It was also hoped that people would
Supply-side economics.
work so much harder and the economy would grow so much faster that the tax
Tax cuts that are intended
to increase aggregate
cut would actually increase tax receipts.
supply by increasing work
The experiment was never really allowed to come to fruition as the Federal
effort, saving, and
Reserve, concerned about possible inflationary effects, slowed the growth of
investment.
the money supply to counter the future effects of the lower taxes and the
currently rapidly increasing inflation. It should not surprise us that there is an
initial effect on the level of total spending. That makes this policy a difficult decision in the midst of
inflationary conditions.
There is little doubt that lower taxes do have some kind of supply-side effect. There is much
agreement that individuals do respond to incentives. The debate among economists and politicians is over
how much. And that, we really do not know. So the debate is over the size not the direction of the effect.
13-6
The consensus over the effects of that type of tax cut is shown in figure 13.3. The effects of the
increased investment will be to increase total spending and eventually to increase aggregate supply. The
major initial effect of the tax cut is on spending. Some of the effect is on supply and full-employment
GDP as shown by the new dashed lines. However, the net effect will be too much spending and we will
be creating inflationary conditions. The spending increase takes us from point A to point B. The
subsequent smaller effect on supply takes us from point B to point C. We get less inflation than if
spending increased alone, but still the policy is an inflationary one.
Figure 13.3
Price Level
Supply Side Effects
175
Full Employment GDP
Full Employment GDP
new
170
165
B
160
155
C
A
Aggregate Supply
150
Aggregate Demand
new
Aggregate Supplynew
145
140
Aggregate Demand
135
0
2
4
6
8
10
12
14
16
Real GDP (trillions of $)
But supply-side economics is not just lowering taxes on individuals. Traditionally, supply-side
capital gains tax cuts and corporate income tax cuts have been used. The theory is that if corporate costs
of investing are lowered through increased tax credits or reductions in corporate profits tax rates,
corporations will undertake increased investment. And the economy will grow faster in the long run. The
traditional supply-side tax cuts, used for example, in the Kennedy-Johnson tax cut of the 1960s, were to
lower taxes on businesses to directly stimulate investment.
Supply-side economics continues to be discussed in presidential campaigns and in Congress. Much
of the debate is centered upon proposals to:
1. reduce corporate income tax and capital gains taxes,
2. reduce taxes on saving, and
3. lower personal income taxes.
The modern supply-side tax cuts discussed in Congress today focus more on capital gains tax cuts and
individual income tax cuts. Reducing taxes on income from saving is intended to increase rewards to
saving. (Earlier we talked about how this effect was a very small one, if it exists at all.) If individuals
increase their saving, investment will increase in the long run. Increased investment will expand capacity
and expand supply.
There is considerable controversy, but the economic consensus is that tax cuts on businesses seem to
be more effective in stimulating supply than tax cuts on individuals. The ability and willingness of
individuals to work harder seem to be limited.
13-7
Figure 13.4
Major provisions in the 1997 tax cut package included:
Per-Child Tax Credit — The agreement provided a $500 per-child tax credit for children under age 17 whose
parents earn up to $75,000 for singles and $110,000 for married couples.
Education Tax Incentives — The bill established a scholarship that gives students a tax credit for the first two
years of college worth 100% of the first $1,000 of their tuition and 50% of their second $1,000. In the third and
fourth years of college the credit is worth 20% of $5,000 of tuition expenses each year.
Capital Gains Tax Cuts — The agreement cut the maximum capital gains tax rate to 20% from 28% for
investments held at least 18 months.
Estate Tax Cuts — The bill gradually increased the amount exempt from the unified gift and estate tax to $1
million from $600,000.
Which of these tax cuts would have had an effect primarily on demand? Which cuts would have had an effect
eventually on supply? Why?
Which of these would you have favored? Why?
Answers to figure 13.4
Per-child tax credit is purely a demand-side cut.
Families with more children receive more disposable
Capital gain. An increase in the value
income. Their consumption will increase. (Some might
of an asset.
argue this is a supply-side cut because it will increase the
Capital gains tax. Currently a 15
supply of children.)
percent tax on gains of assets held over
Education tax incentives are demand-side cuts to
one year.
encourage spending on education. However since much of
education spending has the effect of increasing human
capital, this is similar to a supply-side cut in effect.
Capital gains tax cuts are meant to be supply-side cuts. The reward to business from investing
and individuals from making financial investments in stocks and other financial assets will increase.
However, there is little evidence that such changes are effective.
Estate tax cuts will increase the wealth of those who inherit assets and therefore their
consumption will increase. If, however, estate tax cuts cause individuals leaving the assets to save
more to pass on to children, then those individuals will save more. The evidence is not conclusive as
to which effect is more important.
13-8
New Yorkers Buy Supply Side
By Charles Millard
Last week New Yorkers demonstrated a simple truth. Lower taxes spur economic activity. For one
week the sales tax was eliminated on all articles of clothing costing less than $500. Mayor Rudolph W.
Giulliani is hoping that increased sales will persuade state officials to eliminate this tax for good.
It says a lot about the changes in New York City that we are now in the midst of a classic debate about
whether cutting taxes increases economic activity. Since he was elected four years ago, Mr. Giullani has
fought to get rid of the city and state's combined 8.24% sales tax on clothing, which costs the city an
estimated $700 million in retail activity a year. Much of that activity goes to New Jersey, which levies no
sales tax on clothes. Less retail activity means fewer jobs. New York City has 37% of the metropolitan
area's population. Yet, even though it is a center for business and tourism, it has only 25% of the region's
retail employment.
Mr. Giullani has called on the state Legislature to eliminate the sales tax on clothing in order to spur
job creation and economic activity. His view is grounded in experience. In 1993 New York city's hotel
occupancy tax was the highest in the nation-nearly 25%. In 1994, at the mayor's urging, the tax was
reduced by a third, but total revenue from the hotel occupancy tax rose to $147 million in 1996 from $120
million 1993.
In January 1997, when New York had a sales-tax holiday like last week's, apparel sales rose an
astonishing 73% compared with the previous year. Sales of nonapparel items apparently benefited
indirectly, up 12%.
The state Legislature plans to abolish the clothing sales tax two years from now, but only on items
costing less than $100. Mayor Giullani is calling for total and immediate abolition. My agency estimates
that eliminating the tax would bring the city $1.4 billion in new economic activity and nearly 20,000 new
jobs, and would generate enough new revenues from other sales, corporate and income taxes to recover
some 40% of the forgone sales-tax revenue.
As for the revenue that is not recovered, creating jobs in the free market is a better "jobs program" and
use for those "tax" dollars than having the government spend them. If static thinkers and government
economists believe that cutting taxes hurts the treasury, fails to increase economic activity, helps only the
rich or does not create jobs, maybe they should come to New York City and shop till they drop that point of
view.
The Wall Street Journal, January 29, 1998
Questions
1. Is the demand for clothing inelastic or elastic? Is the demand for clothing in a specific location
inelastic or elastic? Why?
2. What is happening to total tax revenues as a result of the reduction in hotel taxes? What is likely to
happen as a result of the reduction in clothing taxes?
3. Are these supply-side tax cuts?
Answers
1. The demand for clothing is probably inelastic, given that some clothing at least is a necessity.
However, for specific brands or kinds of clothing or clothing in specific places, the demand is
relatively more elastic. The reason is that there are substitutes. It appears from the article that the
demand for hotels in New York is elastic, based on what happened to the total amount spent on
hotels. However, we need to use caution. It could be that demand increased as tastes changes or the
city changed.
2. Reductions in taxes have resulted in more sales. Tax receipts from the hotel tax have actually
increased. But there appears to have been a reduction in total tax revenues related to the clothing
sales tax change. The growth in clothing sales will have to be quite a bit larger to raise total tax
receipts.
13-9
3. These are really demand-side cuts. Supply-side cuts result in an increase in production, not spending.
By lowering tax rates, we get some increase in output but are unlikely to make up the losses in tax
revenues.
The Bush Tax Changes
The 2001 tax cut lowered tax rates and expanded several different tax benefits over a 10-year period.
The tax cuts of 2003 accelerated a number of provisions in the 2001 tax cut and cut taxes on capital gains
and dividends. For the tax year 2003, the 2001 act created the 10 percent tax bracket, reduced most tax
rates by a percentage point or so, made the child credit refundable, and increased it to $600 per child, and
pushed back the phase-out point for the earned income tax credit for joint filers.
The 2003 tax cut accelerated the major provisions of the 2001 tax cut, such as the individual tax rate
reductions, marriage penalty relief, and the $1,000 per child tax credit. It also reduced taxes on capital
gains and stock dividends.
Major changes in taxes in 2001, 2002, and 2003
Individual tax
rates
Child credit
2001 Act
Created 10% bracket.
Reduced
income tax rates as
follows: 39.6% to 38.6%;
36% to 35%; 31% to 30%;
28% to 27%.
Increased from $500 to
$600 per child and made
partially refundable.
No change
2002 Act
Increased from $600 to
$1,000 per child.
Reduced tax rates on capital
gains from 20% to 15% and
from 10% to 5%; tax
dividend income at capital
gains rates (15%/5%).
Capital gains
and dividends
Corporate
expenses
Unemployment
benefits
2003 Act
Expanded 10% bracket.
Reduced income tax rates as
follows: 38.6% to 35%;
35% to 33%; 30% to 28%;
27% to 25%.
Immediate
deduction of 30
percent of many
investments.
Extended
unemployment
benefits
1. Determine the effects of each of these changes on spending in the economy.
2. Are the changes demand side or supply side changes? Why?
13-10
Answers
1. The 2001 changes should have increased disposable income and thus increased consumption
spending. The 2002 deduction of 30 percent of investment made investment on the part of
business firms less expensive and thus should have increased investment spending. The extended
unemployment benefits gave more income to unemployed individuals and should have increased
consumption spending. The 2003 income tax changes should again have increased consumption
spending. The reduced capital gains and dividend taxes should encourage saving.
2. For the most part, each of the changes was meant to stimulate spending to help the economy
recover from the recession of 2001. Thus, the changes were demand side. However, the changes
in taxes to affect investment and saving were supply side changes. The reduction in income taxes
would also have some supply side effects.
Fiscal policy in 2009
The American Recovery and Reinvestment Act of 2009 (passed in February of 2009) designed the
second fiscal policy response to the recession of 2007 – 2009. The act changed spending on goods and
services, transfer payments, and taxes in a number of ways, all designed to stimulate spending in the
economy. The entire bill is estimate to cost $749 billion dollars, an amount equal to more than 5 percent
of GDP at the time. Twenty-two percent of that amount occurs in the seven months of the 2009 federal
government fiscal year remaining after the passage of the bill. Forty-eight percent is spent in fiscal
(October 1 to September 30) year 2010; 16 percent in fiscal year 2011; and the remainder spread out over
the next eight years.
American Recovery and Reinvestment Act of 2009
Payments to state
and local
governments for
infrastructure and
other activities
Tax cuts for
individuals
Transfers to
individuals
Federal spending
on goods and
services
Tax cuts for
businesses
Tax credit
payments to
retirees
Other
Dollar amount
Percent of total
$ 259 billion
33
$ 245 billion
31
$ 100 billion
13
$ 88 billion
11
$ 21 billion
3
$ 18 billion
2
$ 56 billion
7
13-11
The spending on goods and services is and will be done by the federal government and by state and
local governments. It includes a wide variety of activities – health care technology, expansion of
broadband, highway construction, and education. Part of the payments to state governments are to
encourage spending on goods and services, but also to provide funds so that state and local governments
do not need to reduce spending in response to falling tax receipts.
Individual taxpayers will receive tax reductions of approximately 31 percent of the total. Those tax
cuts include $400 tax credits over two years, first-time home buyer credits, and increases in child and
college tuition tax credits. Businesses receive tax cuts of a much smaller amount.
Some of the spending is transfer payments to individuals – primarily extending unemployment
compensation to unemployed individuals – but also one time $250 payments to retirees.
Compare the relative sizes of the ultimate effects of the following in terms
of their effects on total spending. Explain your logic.
Rank the following from 1 (the largest) to 4 (the smallest) in terms of
ultimate effects on GDP.
a.
b.
c.
d.
spending on goods and services
replacement of falling state and local revenues
tax cuts to individuals
transfer payments to unemployed individuals
________
________
________
________
Answers
The rankings should be: a; d; c; and b. The reasoning is that all of the increased spending on goods
and services will increase real GDP and be likely to have a multiplier effect. A large portion of the
transfer payments to unemployed individuals will likely be spent as those individuals need the income to
pay basic expenses. A larger portion of the tax cuts may be saved and thus have a relatively small effect
on spending. Finally, the replacement of falling state and local revenues may have the smallest effect.
This is difficult to determine. If the replacement simply means that state and local governments will
continue to spend what they would have without the decrease in state and local revenues, then the net
effect is zero. However, this leads to new spending, the overall effect could be quite large.
PROBLEMS IN IMPLEMENTING FISCAL POLICY
“The attachment of voters to public services for which they are unwilling to tax themselves
has more or less paralyzed fiscal policy and made it vulnerable to the lowest-commondenominator politics.”
Robert Solow, an economist at MIT
Increases in spending and transfer payments and decreases in income taxes, corporate profits taxes,
and capital gains taxes will increase total spending and stimulate the economy. Decreases in spending
and increases in taxes will slow the economy down. Because changes in spending and in taxes work in
both recessions and inflationary conditions, we have a choice whether to use spending or taxes or both.
The answer is an economic and a political one.
Changes in spending seem to take longer than changes in taxes. The latter can be done within the
matter of weeks. Spending takes months and sometimes years to implement plans.
13-12
In inflationary conditions, it may be difficult politically to raise taxes. Imagine a President addressing
the American people by saying: “I am here to help you. I know you are suffering from higher prices and
lower real incomes. I will propose
tomorrow that Congress raise taxes by
Figure 13.5
ten percent.” Lowering spending may be
politically more successful. But even
BIASES IN FISCAL POLICY
that may be difficult. Any time spending
is lowered, some group of individuals or
SPENDING
TAXES
businesses is hurt and will object.
In a recession, lowering taxes and
EASIER TO INCREASE
EASIER TO LOWER
raising spending may be easier to
accomplish. Given the political ease, it
DIFFICULT TO
DIFFICULT TO
may be politically easier to stimulate the
DECREASE
INCREASE
economy than to slow it down. Thus
there may be a bias toward creating
LARGER
SMALLER
inflationary conditions.
GOVERNMENT
GOVERNMENT
LONGER TIME
SHORTER TIME
In either set of economic conditions,
the choice between changing taxes and
changing spending may be truly a value
judgement. A political conservative may
be much more likely to favor lowering taxes than raising spending to stimulate the economy and favor
lowering spending over raising taxes to slow the economy down.
A liberal who values larger government programs may be much more willing to use increases in
spending to stimulate the economy and increases in taxes to slow the economy down.
Take the on-line self-quiz 13a now.
February 5, 1998, New York Times
Economic Scene: R&D Tax Credit
Free Lunch
By PETER PASSELL
If Americans could vote on their favorite business tax break, the research and development tax credit might
top the balloting. The public supports it because new technology fattens paychecks, saves lives and makes for more
realistic video games. Politicians like it because Corporate America loves it.
Even the bean counters at the Treasury are fans because the credit is designed to yield the maximum bang for
a tax buck.
Indeed, a freshly minted study by Coopers & Lybrand concludes that the research and development tax credit
actually delivers the free lunch that supply-side tax cutters promised, eventually returning more to the government in
revenues as the economy grows than it initially costs.
There's only one catch: As in previous budgets sent to Congress by Presidents Bush and Clinton, the White
House is proposing only a temporary extension. And that undermines the long-term incentives the tax break is
designed to generate. "There is just no good reason for doing it a year at a time," argued Joel Slemrod, an economist
at the University of Michigan's Business School.
Tax credits for corporate spending on research and development have been around in one form or another
since 1981. The current law, set to expire in June, provides a 20 percent credit -- think of it as a
20-cents-on-the-dollar subsidy -- against qualifying research and development outlays.
13-13
"Qualifying" in this case is based on a formula understood only by a select fraternity of tax accountants. But
the idea is simple enough: in order to subsidize only research that would otherwise not have been done, the tax
credits are limited to research and development expenditures above a firm's historic base level.
Economists are generally averse to tax incentives because they distort the prices determined by free markets.
Sometimes such distortions are merely fodder for Dilbert cartoons: offices across America sprouted movable
partitions in the 1960s after the Congress decreed that expenditures on fixed walls did not qualify for the new
investment tax credit. But sometimes the distortions are large: the deductibility of home mortgage interest has
probably led to huge overinvestment in owner-occupied housing, presumably at the expense of rental housing and
industrial capital.
Nonetheless, the academy is solidly behind the tax credit for research and development because it offsets what
is widely viewed as the systemic failure of free markets to allocate adequate resources to research and
development. Study after study has found that corporations capture only about half of the gain from in-house
innovation, with the rest going to other businesses or to consumers.
The late Edwin Mansfield estimated that the private annual rate of return on investment in corporate research
was 25 percent, while the "social" rate of return (including the benefits to others) exceeded 50 percent.
Left on their own, then, corporations have an incentive to invest less on research and development than is
desirable from the perspective of the economy as a whole. The tax credit, which effectively raises the private return,
tends to close the gap with the social return.
Of course, the significance of this distortion depends on how corporate research budgets respond to financial
incentives. But the evidence suggests that corporations are quite sensitive to tax breaks for research. The landmark
study by Bronwyn Hall of the University of California at Berkeley found that the $1 billion spent annually on
research and development tax credits in the 1980's increased research outlays by $2 billion annually. "The payoff is
huge," concurred F.M. Scherer, an economist at Harvard's Kennedy School of Government.
So much for the good news. The original credit, passed in July 1981, lasted until 1988. Since then, however,
its fortunes have been left to capricious gods. The credit has been renewed seven times -- typically as part of
last-minute negotiations. It was suspended from July 1995 to June 1996 when it became hostage to other issues.
The resulting uncertainty has made it harder for companies to forecast their costs, net of credits, on long-term
research projects. And while the impact on private research budgets is unclear, uncertainty has probably cut outlays.
"If the tax credit were permanent, companies would spend $41 billion more on R&D over the next 12 years,"
forecast John Wilkins director for tax policy economics at Coopers & Lybrand. "As long as it remains an annual
affair, we just don't know."
Why, then, has Washington balked at making the credit permanent? Eugene Steuerle, a former Treasury
economist now at the Urban Institute, invokes the fear of creating yet another government entitlement that erodes
the tax base.
But the dominant concern, most agree, is more mundane: If the tax credit were permanent the budget rules
would obligate Congress to find five years' worth of revenues to offset the cost, rather than just one. "The annual
ritual is crazy," Slemrod concludes, but it may be inevitable.
Questions
1. Is the research and development tax credit your favorite business tax credit?
2. What is the importance of the difference between “social” rate of return and the “private” rate
of return? Why would the social rate of return be so much greater than the private rate of
return?
3. Why is the discussion of the temporary or permanent nature of tax cuts so important here?
4. Is this a supply-side or a demand-side cut?
5. If this tax credit is balanced by an increase in other tax revenues, what will be the effect on
our economy?
Answers
1. What the article probably means is that it is the least controversial.
2. The private rate of return is what corporations (and individuals) will use to make decisions. It
is what enters into one’s own cost/benefit analysis. The social rate of return represents what
society should consider when making decisions about economically efficient allocation of
resources. The social rate of return is likely so much greater because individual corporations
are not able to collect all of the benefits of the results of research. Other corporations and
individuals benefit also.
13-14
3. Corporations make plans to invest over periods of years. If the existence of the tax credit is
not clear in future years, it creates additional uncertainty and is likely to reduce the amount
corporations plan to spend.
4. The initial effects are on aggregate demand. The long-run effects are on aggregate supply as
new technology and new products are created out of the research.
5. If income taxes were increased for example, consumption would be reduced and replaced by
increased investment. While the current level of total spending may or may not change, the
economy should grow faster in the future as a result of the increased investment.
Automatic stabilizers
Figure 13.6
We found earlier in this chapter that an increase in
income tax rates would decrease disposable income and
eventually decrease total spending in the economy. Yet the
headline in figure 13.6 says that as the economy grows tax
receipts are rising.
Why the difference? The direction of causation is crucial
in understanding the explanation-. If income tax rates increase, disposable income falls, consumption
falls, and spending shrinks. In this case, tax rates are changing first.
If the spending in the economy is growing for some reason other than changes in tax rates, than with a
fixed income tax rate, tax receipts will actually increase. Twenty-five percent of a growing economy is a
larger number than
Figure 13.7
Direction of Causation Makes a Difference
twenty-five percent
of a smaller
Income increases
Tax receipts increase.
Total spending increases
economy. In this
case, it is spending
However, if
that is rising first.
Tax receipts decrease
Disposable income increases
tax rates decrease
Our tax system
and, to a lesser
Total spending increases.
consumption spending increases
extent, our
government
spending on transfer
payments function as automatic stabilizers. An increase in spending will not have the full-multiplied
effect that it otherwise would because some of the effect is diverted into income taxes and not spent.
Thus the multiplier is smaller because of income taxes. And as spending rises and more people go to
work, transfer payments for unemployment compensation and welfare begin to fall. This also offsets
some of the multiplied effect of the initial change in spending.
The reverse is also true. You make the argument in reverse.
“Tax receipts collapse
as economy continues to
slow”
A decrease in spending will not have the full-multiplied effect that it otherwise would because as
spending falls, incomes falls, and tax payments are lowered. The multiplier is smaller because
disposable income decreases by less than total income. And as spending falls and unemployment
rises, transfer payments for unemployment compensation and welfare begin to increase, partially
13-15
offsetting the fall in income. Both of these events will prevent total spending from decreasing as
much as it otherwise would have.
We can conclude that our economy is more stable as a result of our systems of taxes based on a
percentage of income and transfer payments made to those without jobs or in need. And it happens
automatically. Therefore, the term – automatic stabilizers.
BUDGET DEFICITS AND DEBT
Figure 13.8
The United States is Bankrupt!
The United States Federal Government Debt
Every American Owes $35,000
An advertisement in the 2008 U.S. Presidential campaign
On survey after survey in the 1980s and 1990s individuals identified the rising government deficit and
accumulating federal debt as the most serious economic and political problems. And indeed both were
getting very large. The deficits (and subsequent surpluses) are shown in figure 13.9 and the total debt is
shown in figure 13.10. Taxes were increased in 1990 and 1993, pressure was brought to bear by
Congress and the administration to hold down spending, and the economy has grown rapidly in the last of
the 1990s. Each of these has meant that the deficit was shrinking and has placed the economy in a
position where we reached a budget surplus in 1998.
That surplus continued for four years at which time a combination of lower taxes and higher spending
contributed to record absolute deficits that were significant on a relative basis (as a percentage of GDP).
Figure 13.9
Federal deficits and surpluses
1960 to 2008
Federal deficits and surpluses
as a percentage of GDP
1960 to 2008
300.0
100.0
Percentage of GDP
Billions of dollars
200.0
0.0
-100.0
-200.0
-300.0
-400.0
-500.0
1960
1970
1980
Year
1990
2000
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
-4.0
-5.0
-6.0
1960
1970
1980
1990
2000
Year
13-16
Figure 13.10
Federal debt
(Privately-held portion)
1960 to 2008
100.0
Percentage of GDP
Billions of dollars
6,000.0
5,000.0
4,000.0
3,000.0
2,000.0
1,000.0
0.0
1960
1970
1980
1990
2000
Federal debt as a percentage of GDP
(Privately-held portion of debt)
1960 to 2008
80.0
60.0
40.0
20.0
0.0
1960
1970
1980
1990
2000
Year
Year
Figure 13.11 Federal budget deficits (-) and surpluses (+) in billions of dollars.
1960s to now
High Low
1996
1997
1998 1999 2000
2001 2002
2003
2004
Federal
Budget +$236b -$455b -$108b - $22b $69b $126b $236b $127b -$158b -$378b -$413b
surpluses
and deficits
2005
2006
2007
2008
- $318b -$248b -$161b -$455b
Federal
debt
End of 2008. Total = $10.164 trillion.
Amount in public hands = $5.803 trillion.
Government budget deficit and
surplus. Subtract spending on
goods and services and transfer
payments from revenues. If the
result is a negative number, the
government has a budget deficit. If
it is a positive number, the
government has a surplus.
Federal debt. The sum of all of the
past federal budget deficits and
surpluses.
13-17
Figure 13.12
2008 Budget
in billions of dollars
Estimates
Figure 13.12 shows the current sources of
federal government revenue and categories of
spending. Eighty percent of tax receipts come
directly from individuals. Therefore almost any
attempt to reduce deficits through tax changes is
going to affect individuals directly.
The categories of spending show how difficult
it is to cut government budgets. The vast majority
of the spending is on categories such as interest
payments that simply cannot be cut or items such as
Social Security and Medicare where there are large
groups providing political support.
Receipts
Individual Income Taxes
Social Security/Medicare
Corporate Income Taxes
Other
Expenditures
$2,524
100 %
1,146
900
304
174
45
36
12
7
$2,979
Social Security
National Defense
Nondefense discretionary
Medicare
Other entitlements
Interest
Medicaid
Deficit
100 %
612
612
523
456
322
253
201
21
21
18
15
11
8
7
- $455
Non-defense discretionary spending includes education,
training, science, technology, housing, transportation and
foreign aid.
Other means-tested entitlements provide benefits to people
and families with incomes below certain minimums. The major
programs are Food Stamps, Supplemental Security
income, child nutrition, the earned income tax credit, and
veterans' pensions. Other entitlements include federal
retirement and insurance programs and payments to farmers.
Problem
From time to time, members of Congress have proposed constitutional amendments requiring
the federal budget to be balanced at all times. Assuming such an amendment or law were passed,
analyze the consequences during a recession. Begin by asking what happens to government
revenues as the recession begins.
Answer
As the economy enters a recession, income tax receipts will automatically begin to fall.
(Income decreases as spending falls. Since income tax receipts are a percentage of income, they
decrease.) As revenues fall, a deficit is created. A required balanced budget would mean that we
13-18
would have to raise taxes or reduce spending. That is exactly the wrong fiscal policy at the
beginning of a recession and would make the recession much worse that it otherwise would be.
Greenspan Sounds Alarm on Threat From the Deficit
By Greg Ip
The Wall Street Journal (Edited)
July 21, 2004
WASHINGTON -- U.S. Federal Reserve Chairman Alan Greenspan warned today that the U.S. budget deficit could
become a negative factor confronting the U.S. economy over the longer term.
Completing two days of testimony to Congress on monetary policy, Mr. Greenspan defended the $1.3 trillion in tax
cuts that Congress enacted in 2001, saying the cuts helped stave off a deeper recession than the one the economy
suffered that year. But Mr. Greenspan said he is worried about the outlook for the budget after the end of the current
decade, when the retirement of the Baby Boom generation is expected to drive up the government's outlays for
Social Security and Medicare.
The Fed chief urged Congress to adopt rules that would require spending increases to be offset by tax increases, or
tax cuts to be offset by spending cuts. "Overall, I would say that looking forward, fiscal policy has become a critical
issue on the agenda for macroeconomic policy," he said.
Questions
1. Why would Alan Greenspan care about fiscal policy?
Answers
1.
If we are near full employment and we cut taxes or increase spending, the Fed will likely slow the
growth in the money supply, causing interest rates to rise and investment spending to fall. We will be
replacing investment with consumption and/or government spending.
What is wrong with deficits and debt? Myths and reality.
Before we begin, outline your concerns with a government budget deficit and debt.
13-19
Deficits cause inflation. Indeed they can. If we are at full employment and taxes are lowered or
government spending increased, total spending will rise and we will cause inflation. In the short run,
output will also increase, but eventually the economy will return to the full-employment level of real GDP
with higher rates of inflation. But if we are in a recession, then decreased taxes and increased spending
will cause the economy to return to full-employment with little inflation. So whether or not deficits cause
inflation depends upon current economic conditions. There are improper times and better times to
deliberately increase the deficit or decrease the surplus.
Bankruptcy. Large and growing deficits will add the debt. The argument goes that we will never be
able to pay the debt back. If indeed we could not pay it back or could not make the interest payments on
the debt, then the U.S. government would be bankruptcy. Corporations go into bankruptcy when their
debt grows so that they can no longer meet their obligations. Given that individuals and financial
institutions are willing to loan the federal government money at lower interest rates than any corporation,
they apparently are confident of being repaid.
Passing debt onto children. We do pass debt onto children. But we also pass on assets along with
our debt. We borrow primarily from ourselves. Future generations are responsible for making interest
payments. But those future generations also through pension funds, insurance policies, and financial
investments own the bonds representing the assets. They will also benefit from the roads, bridges,
buildings, and increased productivity the borrowing helped finance. To the extent that bonds are owned
by individuals and institutions abroad, there will be future obligations to make interest payments to
people outside of our borders.
Individuals cannot do it. Individuals are different from governments. Governments live on and do
have the ability to tax workers and corporations in the economy. But individuals do borrow, and some
even increase their borrowing over their lifetimes. It is not an uncommon for adults to take out larger and
larger mortgages on more expensive homes as they are financially more successful.
Definitions of deficits and debt
Inflation accounting. Many would argue that the definitions are wrong. That it is not the total
amount of debt that counts, but the real value of the debt.
Debt as a percentage of income. Others would argue that we should look at debt as a percentage of
GDP. If the percentage is increasing, then perhaps we should be concerned. If it is falling, even if the
absolute amount is rising, the debt is less important. Indeed, Bill Gates can borrow far more than you and
I, and easily pay the interest and the amount of the loan back. Figure 13.13 showing debt as a percentage
of GDP, gives a quite different impression than does the earlier figure 13.10. Figure 13.10 shows the
absolute amounts of debt.
13-20
Figure 13.13
Percentage of GDP
100.0
Federal debt as a percentage of GDP
(Privately-held portion of debt)
1960 to 2008
80.0
60.0
40.0
20.0
0.0
1960
1970
1980
1990
2000
Year
Debt for investment purposes. It is relevant what the government is borrowing for. If the
government is simply borrowing to finance consumption type purchases, than future generations will not
be better off as a result. However, if the government is borrowing to finance education, highways,
research and development, then future generations may well be better off.
Crowding out of investment. Up to now we have considered the direct effects of changes in
government spending, taxes, and transfer payments on total spending and income. When the government
changes spending, taxes, or transfer payments, the government deficit or surplus is changed. An increase
in spending and transfer payments and a decrease in tax rates will increase the deficit or lower the surplus.
Consider the following chain of events. Federal spending increases. The increase in spending causes
a multiplied increase in total spending. That in turn causes an increase in the demand for money. Interest
rates rise. Investment spending falls. But we also know that as total spending rises and real GDP
increases, investment spending will increase. So what does happen to investment spending?
If we are near full employment or producing more than the full-employment output, the increased
spending will not cause a great deal more real GDP. Thus the positive effects on investment will be
small. The net effects are likely to be negative.
If we are in a recession, the increase in spending will have a much larger effect on real GDP. In that
case, the positive effect on investment may be much larger. Then the net effect is likely to be positive.
Increased demand for money
Increase in G
Increased total spending
Increased interest rates
Decreased
Investment
Increased investment in order to expand factories, tools, etc.
If the interest rate effect is largest, investment declines. Economists say that investment then is
“crowded out”. If the total spending creating a need for increased capacity is greater than the interest rate
effect, then there will be more investment, and economists use the very awkward term of “crowding in”.
(Remember they are not poets.)
Another way to understand the phenomenon is to think about the demand for loans. As government
increases its borrowing resulting from the increased deficits, banks are able to increase their interest rates.
Some businesses then begin to cut back on investment. With an economy that has more slack in it, banks
may not be fully loaned out and interest rates may not increase as much.
13-21
Here then is a real cost of rising deficits. They can crowd out investment spending, which means
over the longer run period, we will not grow as rapidly as we could have.
A simplified model
To help us understand the effects of budget deficits, we will create a simple algebraic model of the
circular flow diagram. Assume that the economy is in a long-run equilibrium, that is, at full employment
output. Also assume for the time being, that there is no government spending or taxes and that there is no
international trade.
Then we know that GDP = C + I, and that total income = C + S, C is consumption, I is investment,
and S is saving.
Since in equilibrium, GDP will equal total income:
C + I = C + S,
and therefore
I = S.
The meaning of the result is that if we reduce consumption and the economy returns to full employment
eventually, there will be more resources left over for investment. Therefore, the economy will be able to
grow faster.
Now for a more elaborate model. Let’s remove the assumption about no government. Now we will
include government spending and taxes. Thus,
GDP = C + I + G and total income = C + S + T, where G is government spending and T
is taxes.
Since GDP = total income,
C+I+G=C+S+T
With a little algebra,
I+G=S+T
or
I = S + (T – G)
This is really the same conclusion as above where
Figure 13.14
investment was equal to saving. (T – G) is public
Average annual percent of
real GDP
saving. If there is a government surplus, that is if (T –
G) is positive, there is public saving and there will be
1960-81 1982-Now
more resources left over for investment and higher
growth later. If (T – G) is negative, we have a budget
Federal budget deficit
-.6
-3.0
deficit and some of the resources that could have been
used for investment are used to finance government
Private saving
8.9
6.5
spending and consumption. Investment will be less, and
economic growth in the future will be lower than growth
Investment
7.9
5.0
otherwise would have been.
A more sophisticated model will include net exports
Trade balance
.5
-2.0
and we will do that in the next chapter. Figure 13.14
shows that as the federal budget deficit rose in the 1980s and 90s, investment did fall. Private saving also
fell which we can’t fully explain. We will discuss the change in the trade balance when we add it in the
next chapter. A rising trade deficit may also be partially caused by the increasing federal budget deficit.
13-22
Take on-line self-quiz 13b now.
At Sea With Surpluses
By Herbert Stein
For at least 30 years the U.S. has had, or at least professed, one fiscal
policy: Reduce the deficit, ideally to zero, preferably within five years.
I was never crazy about this policy. I never attached significance to the
number "zero." The only thing one could say about zero was that it was $100
billion less than $100 billion and $100 billion more than negative $100
billion. This becomes obvious if you think of all the different plausible
ways there are to define and measure budget surpluses and deficits.
In the early Reagan years, when the deficit was large, I was not among
those most eager to reduce it. Although I believed that the deficit was
retarding growth by absorbing private saving that would have been
productively invested, I thought that we were a very rich country and had
more important things to do than speed up growth, I was a strong supporter
of the defense buildup and feared that the deficit argument would be used
to restrain it.
Grand Goal in Sight
I changed my mind recently as the deficit declined; this year, the grand
goal of zero seems finally achieved. In fact, I came to believe that
balancing the budget was not enough and that we needed to get to a surplus.
What changed my mind was the ever-clearer prospect that we would run huge
deficits in the 21st century as baby boomers claimed their retirement and
Medicare benefits. Although I was not one who wanted to maximize future
growth, I would not like to see the growth of per capita income turn
negative, and I was afraid that would happen if the federal deficit was so
large as to absorb all private saving.
So I thought we ought to run a surplus now, to reduce the debt and future
interest charges, and that we ought to avoid making commitments now that
would reduce future taxes and increase future expenditures. Although I
myself did not think in these terms, one could say to the budget balancers
that we still will have very large deficits for the next 50 years taken as
a whole, despite being balanced in 1998. One could still invoke antipathy
to deficits as a paramount consideration in fiscal policy.
Now, within a period of less than six months, the picture seems to have
changed racially. Whereas previous estimates–from the Office of Management
and Budget, the congressional budge Office and the General Accounting
Office–all showed large deficits running through the first half of the 21st
century, we now have estimates from the OMB showing large surpluses for
that period, if present tax and spending policies continue.
If these estimates are correct, we have to face the problem of what to do
about surpluses. We had an agreed-upon answer for what to do about
deficits: Reduce them. Even if that did not always appeal to economists, it
was homely wisdom or, as Walter Heller once said, "the Puritan ethic." Even
if it was homely, it was wisdom and even if it was Puritan, it was an
ethic. But we have no wisdom or ethic about surpluses.
There are people who want to reduce taxes and people who want to raise
expenditures. There have always been such people. But in recent years they
have been constrained by the consensus on reducing the deficit and reaching
a surplus. Now no one knows what the surplus constraint is. We are at sea.
We have not had a policy on surpluses for almost 70 years. After World War
I, there was a policy of using surpluses to retire the war debt, and
regular payments on the debt were included in the budget. But surplus
policy was swept away by the Depression, by World War II and by Keynesian
13-23
economics. At the end of World War II, the federal debt was a little over 100% of the
gross domestic product. That was too big for anyone to think about paying
it off. The accepted policy was to grow up to it by avoiding deficits that
would add to the debt while letting the economy expand. We did not avoid
the deficits, but we did grow into the debt through inflation as well as
real economic growth. Now the debt is less than 50% of GDP.
In principle, Keynesian economics provided some guidance to the proper
timing and size of surpluses. Deficits should be large enough to yield high
employment, and surpluses should be big enough to avoid overheating the
economy. But while much was heard from Keynesians about the need for
deficits, I can't remember any argument for a surplus on Keynesian grounds.
The current arguments about cutting taxes or raising expenditures proceed
without reference to any principle about how big a surplus ought to be. We
need to discuss that question and try to reach some consensus about it.
President Clinton has said that we should not do anything with the surplus
until we have dealt with the Social Security "problem," whatever that is.
This is only an excuse to defer thinking seriously about what our long-run
surplus policy ought to be. I don't believe we can come to any sensible
decision about the expected cash deficit in the Social Security funds
without simultaneously deciding about the long-run policy for the surplus.
We can bring the Social Security funds into balance by measures internal to
the system, such as cutting the promised benefits, or by a contribution
from the federal funds of the federal government. Which we choose will
affect the size of the unified budget surplus. We should decide our policy
about that surplus before, or concurrent with, the decision about Social
Security.
I don't know what our long-range surplus policy should be, but I would
think about it as a problem of choice between the present generation and
future generations. The more surplus we retain and use to retire debt, the
larger will be the supply of private saving available for investment, the
larger will be the stock of productive capital, and the higher will be
future incomes. On the other hand, we can provide benefits for the present
generation by cutting taxes or increasing expenditures.
When we seemed to be facing large deficits in the next century that would
seriously slow down the growth of the capital stock and injure the next
generation, I leaned heavily toward retaining the surplus while we had it
and retiring debt. But if we are going to have large surpluses in the
future, I am not so sure.
Unreliable Forecasts
In the past year, we have learned one thing about budgets: Forecasts of a
deficit or surplus can be extremely unreliable. In February 1997 Mr.
Clinton submitted a budget with a deficit of $121 billion for fiscal 1998.
In March 1997 the Congressional Budget Office re-estimated the effects of
the president's policies and concluded that they would yield a deficit of
$145 billion. As of this writing, it appears there may be a surplus of
about $60 billion. If there can be so much error about the current year, we
have to be very cautious about attaching weight to a forecast surplus 20 to
30 years from now. That is a reason for not committing ourselves to tax cuts
or expenditure increases that will be hard to undo later. One thing we should
certainly do for our children and grandchildren is to leave them room for
decisions when the facts become clearer.
I don't know any substitute for the good-judgment and responsibility of
our elected representatives in deciding on a long-run policy about
surpluses. They are the one who have to make
the choice between the present and future, since the future is not here to
participate in the decision. But we should consider the problem as
explicitly as possible, rather than leaving the outcome to the vagaries of
13-24
fragmented and short-term decisions about taxing and spending.
Herbert Stein was Chair of the President’s Council of Economic Advisers under
President Nixon.
The Wall Street Journal, May 19, 1998
Questions
1.
2.
3.
4.
5.
What is the problem?
What are the relevant economic goals?
What are the options?
Analyze each option as to how each goal will be met.
Rank the importance of your goals and then choose a policy.
Answers
1.
2.
3.
4.
5.
The problem is what to do about the current and projected future surpluses.
Goals might include:
a. Raise our current average standard of living.
b. Raise future standards of living.
c. Keep government small.
d. Satisfy our needs for additional government services.
Options might include, among others:
Cut taxes
Increase spending
Do nothing, that is, let the surpluses occur
Cutting taxes and raising government spending will increase current standards of living. Cutting taxes will
satisfy the third goal; raising spending will satisfy the fourth. Doing nothing will mean more investment in
the future and higher standards of living.
The final choice depends upon the relative weighting of the goals. The following table may help.
Current
well-being
Cut taxes
Increase spending
Do nothing
+
+
-
Future
Small
Additional
well-being government government
+
+
-
+
-
If my only important goal is to ensure future growth then I will choose do nothing. If my goals are to keep
government small and maximize current standards of living, the cutting taxes option makes the most sense.
The Budget Outlook: Analysis and Implications
William G. Gale and Peter Orszag, Urban Institute, October 06, 2003
“The Congressional Budget Office's midyear update of the economic and budget outlook,
released in late August, provides an opportunity to glean new perspectives on the fiscal status of
the federal government. In a prior article, we adjusted the baseline projections to provide more
appropriate measures of the implications of continuing current policy and of the underlying
financial status of the government (Gale and Orszag 2003c). In this article, we assess the budget
outlook and discuss implications for policy, with the following principal conclusions:
• Realistic budget projections show a fundamental, persistent, and growing shortfall of
projected revenues relative to spending. This implies that the United States is on an
13-25
unsustainable long-term fiscal path and an imbalanced medium-term path. Although the CBO
baseline projects unified deficits that average 1 percent of GDP and shrink over the next decade,
realistic assumptions about current policy imply persistent deficits in excess of 3 percent of GDP
in the unified budget and in excess of 5 percent of GDP exclusive of retirement trust funds. Under
reasonable assumptions about current policy, public debt will rise significantly and continually as
a share of GDP over the next decade, and the full-employment deficit excluding the Social
Security Trust Fund will remain near postwar highs as a share of GDP for the latter half of the
decade. All budget projections deteriorate sharply and permanently after the current decade
ends.
• The deterioration in budget outcomes over the next decade is due largely to a decline in
revenues relative to prior projections and relative to earlier years. Revenues are projected to be
more than 1 percent of GDP lower in the next decade than over the previous 40 years, whereas
spending is projected to be at its average share of GDP. Between January 2001 and August
2003, the projected budget surplus for 2010 declined by $941 billion, of which 43 percent is due
to lower revenues and 17 percent is due to increased homeland security and defense spending.
Net interest payments — allocated in rough proportion to the two items above — account for 39
percent of the decline. Increased spending on all other items accounts for just 1 percent of the
decline.
• It is unlikely that any realistic revision to economic growth projections would be sufficient to
make the budget problem disappear.
• If the unified budget, based on realistic assumptions, were to be balanced by spending cuts
alone, the required reductions would be substantial. For example, eliminating the projected
(adjusted) unified deficit in 2008 would require a 17 percent cut in all non-interest outlays in that
year or a 57 percent cut in all outlays other than defense, homeland security, net interest, Social
Security, Medicare, and Medicaid. (For purposes of illustration, these figures focus exclusively on
policy changes in 2008 and assume no changes before then.)
• Extending the administration's tax cuts, which expire by 2011, and the other expiring
provisions in the tax code would reduce revenues on a permanent basis by 2.5 percent of GDP.
This decline is larger than the shortfalls in the Social Security and Medicare Hospital Insurance
Trust Funds over the next 75 years.
• The administration essentially has no policy to address these issues. It claims its policy is to
cut spending and to cut taxes to make the economy grow. But it is raising spending, and even if
its tax cuts raise growth — which most studies find to be unlikely — the effects on growth will be
insufficient to offset the direct revenue losses, as even the administration's own writings
conclude. In other words, it is entirely implausible that the tax cuts are "part of the solution" to the
projected budget imbalance, rather than part of the problem.
• A realistic policy response would (a) reimpose the budget rules that have expired, (b) trim
spending, and (c) allow at least the bulk of the expiring tax provisions to sunset as scheduled and
roll back some of the more egregious features of the recent tax cuts before they are scheduled to
sunset.“
1.
2.
3.
4.
5.
What are the policy options?
What are the relevant economic goals and concepts?
Analyze each of the policy options.
Rank according each according to your goals.
Choose a policy based on the relative importance of your goals.
Summary of monetary and fiscal policy effectiveness discussions
Policy is slow to work. Part of the challenge in managing fiscal policy and monetary policy is that we
must forecast future conditions. There are considerable lags between the time events happen in the
economy and the time our policies begin to change conditions. The data lag (in figure 13.15) is a lag
13-26
between the time the event happens and the time we recognize it. Preliminary real GDP estimates come
out one month after the end of a quarter; unemployment figures are produced one week after the end of
the month; and inflation figures appear two weeks after the end of the month. But we do not normally
base decisions on just one piece of evidence. We wait to see if a trend is developing. So the recognition
lag is the time we wait for a new set of data to be generated.
The legislative lag is the time it takes Congress and the President to get the legislation completed in
the case of fiscal policy and the time for the Federal Reserve to act in the case of monetary policy. That
legislative lag can be quite long for fiscal policy; and is very short for the Federal Reserve. The
transmission lag is how long it takes between the time we have decided to do something and when we
actually do it. The transmission lag is tomorrow for the Federal Reserve. It is weeks for tax changes and
months for spending changes. Finally, there is a time period before policy changes begin to have their
full effects. That length of time for both fiscal and monetary policy seems to change and be difficult to
predict. Nine months for monetary policy and two to nine months for fiscal policy are reasonable
estimates.
Figure 13.15 Policy Lags
Monetary
Policy
(months)
Fiscal
Policy
(months)
Data
2
2
Recognition
2
2
Legislative
.5
4 – 36
Transmission
1
1–9
Effectiveness
9
6–9
Total Lag
14.5
15 – 58
We add all those together and the total lag for monetary policy is more than 14 months and for fiscal
policy, a range of 15 to 58 months. Given these time lags, the President, Congress, and the Fed cannot
wait for events to happen. They instead must predict what the future holds and then make a decision to
implement policy now. If we know that monetary policy takes 14 months before it begins to take effect,
then we must forecast economic conditions 14 months from now and make a decision now to do
something about it. It is even more challenging for fiscal policy. Unfortunately, economists are not very
good at making those forecasts.
13-27
Figure 13.15
Summary of Monetary and Fiscal Policies
Monetary Policy
Fiscal Policy
Who
Federal Reserve
Executive and legislative branches
How
Open market operations
Spending, taxes, and transfer
payments
Reserve requirements
Discount rate
Timing
Effects on spending
Short policy lag
Long policy lag
Long expenditure lag
Shorter expenditure lag
Total = 14 - 15 months
Total = 11 - 58 months
Investment,
Government goods and services
Consumption, and
Effects on growth
Expansionary policy
Transfer payments
Net exports
Consumption or investment when
taxes are changed
Investment increases
Investment may increase or decrease
Restrictive policy
Investment may increase or decrease
Investment decreases
Effects on inflation
(Expansionary policy)
Inflation increases
Inflation increases
Biases and Problems
Possible problem to stimulate
Easier to stimulate
Specific industries are affected
Politically difficult to contract
Difficult to define money
Difficult to forecast accurately
Difficult to forecast accurately
Supply shocks present difficult
policy choices
Supply shocks present difficult
policy choices
Long run versus short run effects
Long run versus short run effects
Effects of saving – surpluses and
deficits
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February 17, 1998
Wall Street Journal
Jeers for the Budget Surplus
By ROBERT EISNER
Last July, when the editors of this newspaper wrote an editorial on a
Republican proposal to run federal budget surpluses, they headlined it
"Invincible Ignorance." Today those words are sadly, similarly apt for
President Clinton's recommendation, now that surpluses are at hand, that
we "reserve" every penny for Social Security.
The government running a surplus, whether "reserved" for Social Security
or anything else, means taking more in taxes than it gives the public in
outlays. That should please nobody, neither liberals looking for more
public investment nor conservatives who want business and households to
have more freedom to make their own private spending decisions.
Already Declining
What a budget surplus would do, by definition, is reduce the federal debt
held by the public, currently some $3.8 trillion. A deficit means borrowing,
thus increasing the debt; a surplus means paying off previous borrowing.
But in an economically relevant sense, as a portion of our national income
or gross domestic product, the federal debt is already declining rapidly.
From some 50% of GDP a year ago - and it was over 110% of GDP after
World War II - a balanced budget itself, without any surplus, will cut that
ratio to less than 47% this year and keep reducing it year after year.
Thinking that the federal debt is like their own, people view its reduction as
somehow making them better off. But that debt is not their debt. It is the
debt of the government to them. It is their asset. Would we rather owe the
government? If the government kept running substantial surpluses it would
end up owning us. Once the debt were down to zero and the Treasury
were finished buying back its own securities, it would start using our taxes
to buy up our homes and businesses and what had been our financial
wealth.
(1)
(2)
Reducing the federal debt by the $200 billion of surpluses anticipated over
the next five years would mean leaving us with $200 billion less of financial
wealth in the form of savings bonds and other Treasury securities. What
(3)
we would have instead is the canceled checks for the taxes that were used
to pay off the debt.
With less financial wealth and more to pay in taxes, the public is forced to
consume less. And to what purpose? To increase saving and investment?
Many assert that higher taxes forcing less consumption will necessarily
cause more saving and investment. But that is hardly certain, and is often
unlikely. If I do not buy a new car, will the automobile manufacturer invest
more - or less?
(4)
And what does all this have to do with Social Security? As analysts
without an axe to grind have observed, Social Security is in no crisis. The
suggestion that it is stems often from uncertain forecasts that the Old Age
and Survivors and Disability Insurance trust funds will be "running out of
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money" by 2030. Using the surpluses to add to the OASDI funds, if that is
what anyone in the administration has in mind, would then delay that still
distant doom another 10 years.
But in fact our Social Security checks do not come from the trust funds.
They come directly from the U.S. Treasury. The funds could be abolished
and the Treasury could readily go on collecting the same taxes and paying
us the same benefits. With or without trust funds, our future Social Security
benefits are specified by law and we can expect to get them as long as the
voting public sees to it that we do.
What then does Mr. Clinton mean by holding "every penny" of prospective
budget surpluses for Social Security? It simply preserves the surplus, with
the Treasury thus continuing to take from the public more than it pays out,
reducing the public's financial assets of Treasury bills, notes and bonds.
By preserving the budget surplus we waste it. "Paying down" the
debt will be likely to reduce the public and private investment so
important to our future.
(5)
If the currently anticipated $200 billion of surpluses over the next five
years is credited to the OASDI accounts, their computer balances will be
higher by that amount and by the interest income credited on those
balances. The Treasury will go through the motion of printing "hard copy"
for those balances in the form of non-negotiable Treasury obligations. This
in no way increases the ability of the Treasury to pay out benefits. The
Treasury checks will still bounce unless they are financed by taxes or by
borrowing.
If increasing balances in the fund accounts seems necessary to reassure the
baby boomers that Social Security will "be there" for them, we can do that
easily without budget surpluses. Those balances are accounts in the
computer. They are built up primarily by crediting to them a particular
tax on payrolls. This is a fairly inequitable tax at that, with no exemptions
or progressivity, discouraging labor and falling particularly hard on working
families.
But we can readily credit other tax receipts to the OASDI trust funds, just
as we do in the case of the Hospital Insurance trust fund (Medicare Part
A). For example, we could add, to those 12.4% payroll tax credits, credits of income
taxes equal to 1.5% of taxable incomes. Crediting the
trust fund accounts these additional amounts would put them indefinitely in
black ink. This would indeed be a more reliable source of credits than the
variable portion of general revenues that constitutes budget surpluses.
Crediting more revenues to the trust fund accounts, however, whether out
of a specific income tax credit or out of less certain budget surpluses,
would have no effect whatsoever on government spending or taxing or the
debt to the public. Neither would it make any difference for the real issue
for Social Security - an aging population.
The bread eaten by those not working must be baked by those working.
When the numerous baby boomers retire and no longer produce for
themselves, they will require support from the smaller Generation X then
(6)
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working.
No Future Doom
However, this real issue also need not raise a specter of future doom. With
even a modest 1% per year growth in worker productivity - and our recent
robust growth that has turned the deficit to surplus has been greater - we
will have some 37% more output per worker in the year 2030. That will
be enough, even with the predicted 10% increase in the burden on the
working population, to offer 25% additional real income per capita to all,
young and old. And this plenty can be increased all the more if we achieve
and maintain maximum employment and maximum investment in the skills
and productivity of the American people.
But holding budget surpluses for Social Security has nothing to do with
this. In effect, by preserving the budget surplus we waste it. Not using the
surplus means no additional funds by direct spending or targeted tax
credits for old or new programs to invest in education, research, child
care, health, infrastructure or the environment. It also means no general tax
cut to offer the public more to spend on its own. This "paying down" the
debt will be likely to reduce the public and private investment so important
to our future.
(7)
Mr. Eisner, professor emeritus at Northwestern University and a past
president of the American Economic Association, is the author, most
recently, of "The Great Deficit Scares: The Federal Budget, Trade
and Social Security."
Case Questions
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Should the debt be evaluated by its absolute size or its size relative to GDP? Why?
Is the federal debt an asset or a debt?
Is there no benefit to a reduction in the debt?
Is saving equal to investment? Or is Eisner correct?
Will an increase in public saving reduce investment: What is Eisner actually arguing?
Think back to the discussion of economic growth. What does this paragraph mean?
What is your proposed policy regarding the federal budget surplus?
Take on-line self-quiz 13c now.
Summary
•
•
•
Fiscal policy is the deliberate change in spending and taxes by the federal government in
efforts to influence economic conditions in the economy.
Changes in spending and taxes for other reasons, for example, to expand education or to
lower taxes on certain types to income, will also have unintended effects on economic
conditions.
To stimulate spending in an economy, a government can lower taxes, increase
government spending on goods and services, or increase government transfer payments.
13-31
•
•
•
•
•
To slow growth in spending in an economy, a government can increase taxes, decrease
government spending on goods and services, or decrease government transfer payments.
Changes in taxes and spending can also have effects on incentives and aggregate supply
conditions in an economy. To increase aggregate supply, a government can lower taxes
to increase incentives to work, save, and invest or direct spending toward investment in
physical and human capital and research and development.
Government deficits increasing as a percentage of GDP do have costs. The primary cost
is the eventual crowding out of private investment and the eventual slower economic
growth.
Government debt is the sum of all past government deficits and surpluses. Government
finance deficits and debt by issuing government bonds.
Fiscal policy does have a significant lag between the recognition of the necessity to
undertake a policy and the effects of that policy. The political decision-making process
can create a very long lag.
Key Concepts in Chapter 13
Fiscal policy
Government spending on goods and services
Taxes
Transfer payments
Surpluses, deficits, and debt – Measurement, myths, and meaning
Using fiscal and monetary policy together
Chapter Review Questions
(Many of the following questions bring monetary and fiscal policy together and are good reviews
of both of the last two chapters.)
1. If growth in the economy is increasing and inflation is rising, which of the following
combinations of fiscal policy would be most effective in reducing inflation?
a. an increase of $100 billion in taxes and an increase of $100 billion in government
spending on goods and services.
b. an increase of $100 billion in taxes and a decrease of $100 billion in government
spending on goods and services.
c. a decrease of $100 billion in taxes and an increase of $100 billion in government
spending on goods and services.
d. a decrease of $100 billion in taxes and a decrease of $100 billion in government
spending on goods and services.
2. Which of the following combinations of fiscal policies would you recommend as most
effective (a) if the economy is producing at a level of real GDP that is less than the potential
level and (b) if you want to stimulate the economy without making the deficit larger?
a. an equal decrease in taxes and in government spending on goods and services.
b. an increase in taxes that is equal to the decrease in government spending on goods and
services.
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c. a decrease in taxes that is equal to the increase in government spending on goods and
services.
d. an equal increase in taxes and in government spending on goods and services.
3. Given an increase in oil prices, an individual who is most concerned about inflation and less
concerned about unemployment will choose which of the following policies?
a.
b.
c.
d.
4.
a decrease in taxes and a decrease in government spending.
a decrease in taxes and an increase in government spending.
an increase in taxes and an increase in government spending.
an increase in taxes and a decrease in government spending.
A stimulative fiscal policy will cause which of the following:
a. an increase in investment, if real GDP is already above the potential level
b. a decrease in investment, if real GDP is significantly below the level of potential real
GDP
c. a rise in interest rates
d. a decrease in the money supply
5.
An increase in government spending combined with an equal increase in taxes will have
which of the following effects on an economy?
a.
b.
c.
d.
increase in real GDP and an increase in prices
increase in real GDP and a decrease in prices
decrease in real GDP and an increase in prices
decrease in real GDP and a decrease in prices
6. If the President's goals are to increase the size of government and to solve unemployment
problems after a fall in aggregate demand, the President should
a.
b.
c.
d.
7.
increase taxes.
decrease taxes.
decrease taxes and decrease government spending by the same amount.
increase government spending.
Assume the economy is in long-run equilibrium. Government decreases taxes to fulfill
campaign promises. What happens in the economy in the short run? in the long run?
a. an increase in real GDP and prices, followed in the long run by decreasing real GDP and
prices.
b. a decrease in real GDP and prices, followed in the long run by decreasing real GDP and
prices.
c. an increase in real GDP and prices, followed in the long run by decreasing real GDP and
increasing prices.
d. a decrease in real GDP and prices, followed in the long run by increasing real GDP and
decreasing prices.
8.
Assume (1) the deficit would be zero if the economy were at full employment but (2) the
economy currently has a rather large unemployment rate. Which of the following must be
true?
13-33
a.
b.
c.
d.
The actual deficit must be zero.
The actual budget must have a deficit.
The actual budget must have a surplus.
The economy must be growing.
9. Which of the following is true, if nothing else changes?
a. If the federal budget deficit is reduced, the national debt will stop growing.
b. If the federal budget is in surplus, the national debt will get larger.
c. If the Federal Reserve decreases the money supply, the federal budget deficit will likely
get larger.
d. Inflation will be reduced if the Federal Reserve purchases the bonds issued to fund the
federal budget deficit.
10. Given a supply shock that moves the economy from a long-run equilibrium to a new shortrun equilibrium at less than full-employment GDP, which of the following policies would be
appropriate if the goal was to reduce inflation?
a.
b.
c.
d.
Raise taxes.
Lower taxes.
Raise government spending.
Raise taxes and raise government spending by the same amount.
11. A balanced budget amendment is passed and is made effective in a time when the economy
is producing a level of real GDP that is less than the potential. The federal budget is currently
in deficit. What should the Federal Reserve do?
a.
b.
c.
d.
Raise taxes
Buy bonds
Raise the reserve requirement
Reduce spending
12. Which of the following statements comparing the lags of monetary and fiscal policy is
accurate?
a. The lag between the initiation of fiscal policy and the effect on real GDP is longer than
the lag between the initiation of monetary policy and its effects
b. The policy-making lag for fiscal policy is longer than monetary policy.
c. Monetary policy takes longer to have an effect on the economy if the economy is
growing than if the economy is entering a recession.
d. The total amount of time from beginning to end for fiscal policy is significantly shorter
than for monetary policy.
13. Assume that the economy is at full employment level of real GDP and remains there. Also
assume that saving and net exports do not change. What is the actual cost of an increase in
the federal budget deficit? Think opportunity cost here. Explain how you got your answer.
14. "Over one and a half million people were laid off from jobs following the doubling of oil
prices in 1979." What was the policy dilemma faced by monetary and fiscal policy makers?
13-34
15. Assume we are currently at full employment. Assume a new administration decides to use
fiscal policy to lower unemployment even further and to keep unemployment at the lower
level. Explain briefly how the policy would affect the economy in the short and long run.
16. Assume that we are currently producing less than the potential level of GDP. What is a
legitimate argument against actually using monetary or fiscal policy?
17. Once the decision has been made to use monetary and fiscal policy to solve a problem, which
policy takes longer to have an effect on real GDP and the price level? Why?
18. a. Assume that we are currently producing less than the potential level of GDP. Make a
brief argument for active use of monetary policy instead of fiscal policy.
b. Given the same situation, make a brief argument for not using either monetary or fiscal
policy actively.
19. "An increase in the budget deficit can be beneficial for the economy," said a member of
congress during the November budget debates. Explain under what circumstances and why
this member of congress might be correct.
20. Explain the difference between crowding out and crowding in. Why does each occur?
Answers
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
B
D
D
C
A
D
C
B
C
A
B
B
In equilibrium, spending (C + I + G + NX) equals income. Income, by definition, equals C +
S + T. Thus investment will equal private saving plus the government surplus (or deficit, if G
is larger than T) minus net exports. I = S + (T - G) - NX. If the economy is at full
employment and remains there and saving and net exports do not change, then an increase in
the government deficit will mean that less saving is left over for investment.
Since investment must decrease, the opportunity cost of the increased government deficit
is the forgone investment spending with its accompanying increased capacity to produce
more goods and services in the future. [In the next chapter, the answer becomes a bit more
involved as we consider the effects on net exports also. But the fundamental correctness of
this answer remains.]
14. The policy dilemma is rising prices and rising unemployment. If policy is used to stimulate
the economy, inflation will rise further. If policy is used to slow the economy down,
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unemployment will rise. If tax and spending policy is used to increase supply, it is likely that
spending will increase before supply, thus causing more inflation.
15. The policy would decrease unemployment in the short run and cause increased inflation. In
the long run as expectations of even higher prices occur, wages would increase. This would
tend to bring unemployment back up to the higher level and increase prices even further. If
the government increased spending again to hold unemployment down, the ultimate effect
would be a continual rise in prices at the lower level of unemployment. The increase in the
government deficit as a result of the stimulus would mean that interest rates would begin to
rise. Investment spending would be reduced, partially offsetting the increase in overall
spending. There would be more government or consumption spending and less investment
spending.
16. There are several possibilities. Here are two key components:
1. The economy left alone will eventually return to the potential level as wages fall.
2. The use of monetary or fiscal policy will cause higher prices at full employment than if we
just let the economy adjust on its own.
or
If we use active policy, we may make a mistake given forecasting difficulties, lag times, and
the tendency to stimulate the economy too much.
or
If the cause of the short-run equilibrium below full-employment output is a negative supply
shock, then the active use of monetary and fiscal policy will make one already bad problem
worse.
17. Monetary policy will take longer, because monetary policy works by changing the money
supply which starts a long process. The change in the money supply changes interest rates,
which changes investment spending, which changes total spending. Fiscal policy works to
change total spending directly in the case of changes in government spending and almost
directly in the case of changes in taxes.
18. a. Fiscal policy may cause crowding out of investment when the economy is nearing full
employment. If the government is concerned with the amount of investment and long-run
economic growth, the desired policy might be to use an increase in the money supply to lower
interest rates to increase investment.
b. If the economy quickly adjusts to full employment through falling wages, it may be better
to not use fiscal or monetary policy. The active use of policy will cause higher inflation and
only return us to the same level of output that would be accomplished naturally.
19. An increase in the budget deficit will benefit the economy when the economy is in a
recession. An increase in government spending or a decrease in taxes will cause growth in
total spending.
20. When the federal budget deficit is increased there are two effects, which one dominates
determines whether crowding out or crowding in occurs.
An increased deficit means that government spending has increased or taxes have
decreased. The stimulus to spending is a positive one and will cause more investment as real
GDP increases. The increased deficit also means that interest rates will increase, raising the
cost of investment. Thus investment will fall. If the latter effect is larger than the first, we
will have crowding out. Investment spending decreases. If the first is larger, we have
crowding in, that is an increase in investment.
13-36
Glossary
Automatic stabilizers. Our system of income taxes and government transfer payments functions
in a manner that reduces the effects on total spending of changes in consumption, investment,
government spending on goods and services, and net exports.
Capital gain. An increase in the value of an asset.
Capital gains tax. A tax on the capital gain earned when an asset is sold.
Corporate profits tax. Federal government taxes on corporate profits.
Federal debt. The sum of all of the past federal budget deficits and surpluses.
Fiscal policy. Most often refers to deliberate actions by the federal government to change taxes
and spending with a goal of influencing economic conditions. Also includes tax and
spending changes undertaken for other reasons.
Government budget deficit and surplus. Subtract spending on goods and services and transfer
payments from revenues. If the result is a negative number, the government has a budget
deficit. If it is a positive number, the government has a surplus.
Investment tax credit. A reduction (or credit) in a corporation’s tax, calculated as a percentage
of the amount spent on investment.
Reaganomics. The income tax reductions passed while Ronald Reagan was President. The tax
reductions were intended to increase productivity and investment, while at the same time not
increasing the federal budget deficit.
Restrictive fiscal policy. A fiscal policy meant to reduce inflationary pressures. Normally an
increase in taxes or a reduction in spending and transfer payments.
Stimulative fiscal policy. A fiscal policy meant to reduce unemployment. Normally a decrease
in taxes or an increase in spending and transfer payments.
Supply-side tax cuts. Tax cuts that are intended to increase aggregate supply by increasing work
effort, saving, and investment.
Transfer payments. Government payments to individuals, such as social security, welfare, and
Medicare.
13-37