Download Macroeconomic Policy Debates

Economics
NINTH EDITION
Chapter 17
Macroeconomic
Policy Debates
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Learning Objectives
17.1 List the benefits and the costs for a country of running
a deficit.
17.2 Summarize the arguments in favor of inflation
targeting.
17.3 Describe the key differences between income and
consumption taxes.
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17.1 SHOULD WE BALANCE THE
FEDERAL BUDGET? (1 of 7)
The Budget in
Recent Decades
The nation’s debt/GDP
ratio tends to rise sharply
during wars because
more spending is needed
to finance them.
However, the ratio also
can rise during
peacetime, as it did
during the Reagan
presidency in the 1980s
and since 2008.
SOURCES: Congressional Budget Office, “The Long-Term Budget Outlook,”
December 2003, and yearly updates.
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17.1 SHOULD WE BALANCE THE
FEDERAL BUDGET? (2 of 7)
Five Debates About Deficits
DEBATE 1: DO DEFICITS LEAD TO INFLATION?
Government deficit = new borrowing from the public + new money created
●
Monetizing the deficit
Purchases by a central bank of newly issued government bonds.
Large, stable countries like the United Kingdom, the United States, and Japan don’t
monetize much of their debt because they are able to borrow from the public. In these
countries, deficits do not lead inevitably to inflation.
During the recent recession, the Fed purchased massive amounts of bonds, but paid
banks interest thus inducing them to hold additional reserves. This prevented a large
increase in the money supply held by the public.
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17.1 SHOULD WE BALANCE THE
FEDERAL BUDGET? (3 of 7)
Five Debates About Deficits
DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON FUTURE GENERATIONS?
The result of government deficits is that less savings are available to firms for investment.
Higher taxes will be imposed on future generations
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
●
Ricardian equivalence
The proposition that it does not matter whether government expenditure is financed by taxes
or debt.
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17.1 SHOULD WE BALANCE THE
FEDERAL BUDGET? (4 of 7)
Five Debates About
Deficits
DEBATE 2: IS
GOVERNMENT DEBT A
BURDEN ON FUTURE
GENERATIONS?
Among developed countries,
the United States has a
relatively small percentage
of debt to GDP.
Japan has the highest
percentage of debt of the
countries depicted.
SOURCE: Central Intelligence Agency, The World Factbook,
https://www.cia.gov/library/publications/the-world-factbook/rankorder/2186rank.html,
accessed March 2015.
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17.1 SHOULD WE BALANCE THE
FEDERAL BUDGET? (5 of 7)
Five Debates About Deficits
DEBATE 3: HOW DO DEFICITS AFFECT THE SIZE OF GOVERNMENT?
Nobel Laureate James Buchanan has argued that people are less aware of government
deficits than of the taxes they’re forced to pay.
Therefore, financing government expenditures through deficits, rather than through higher
taxes, will inevitably lead to higher government spending and bigger government.
Although this argument may seem plausible, it presents two problems:
First, in recent U.S. history, spending by state and local governments has grown much
faster than federal spending. However, state and local governments face many more
restrictions when it comes to borrowing money than the federal government faces.
Second, if politicians trying to get reelected really prefer higher government spending and
deficits to higher taxes and surpluses, why did the federal government run surpluses in the
late 1990s?
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17.1 SHOULD WE BALANCE THE
FEDERAL BUDGET? (6 of 7)
Five Debates About Deficits
DEBATE 4: CAN DEFICITS BE GOOD FOR AN ECONOMY?
The government may deliberately run a deficit to pull the economy out of a recession. The deficit
the government creates puts additional income into the hands of the public.
With more money, people don’t have to drastically cut their consumption spending. Because total
spending in the economy does not fall as much, the severity of the recession is lessened.
Deficits can also play a role in tax smoothing during periods of unusually high government
expenditures.
By running deficits and only gradually raising taxes later to service the debt, we avoid creating
excess distortions in the economy.
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17.1 SHOULD WE BALANCE THE
FEDERAL BUDGET? (7 of 7)
Five Debates About Deficits
DEBATE 5: WOULD A BALANCED-BUDGET AMENDMENT REALLY WORK?
Proponents of the balanced-budget amendment say it will finally exert discipline on the federal
government, preventing large deficits in peacetime, such as those that occurred in the 1980s.
Critics of a balanced-budget amendment point to many different problems, such as the following:
• A balanced budget may not allow enough flexibility, or room, for the government to effectively deal
with recessions.
• The Constitution is not the right mechanism to try to enforce complicated budget rules.
• Congress could devise special budgets to get around the requirement.
• Congress could also find non budgetary ways to carry out the policies that it desires.
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APPLICATION 1
CREATING THE U.S. FEDERAL FISCAL SYSTEM THROUGH DEBT POLICY
•
APPLYING THE CONCEPTS #1: Why did the early U.S. federal government take over the debts of
the thirteen colonies?
•
• When the United States enacted its new Constitution in 1789, it replaced the Continental
Congress and centralized power in the federal government. The federal government became
the sole power to be able to raise revenue through tariffs on imported goods, but also
assumed the debts of the state governments. Alexander Hamilton, who conceived and
promoted this new arrangement, saw it as a way to strengthen the federal government so that
it could borrow externally as needed for wars or other needs. The states were willing to give
the tariff power to the federal government in exchange being absolved of their debts.
• Nobel Laureate Thomas J. Sargent noted, however, that when the states again got into fiscal
difficulties in the 1840s through overly ambitious infrastructure investment, the federal
government did not bail out the states. This time, the federal government did not want to
enhance its power and control over the states, which were forced to impose new rules and
fiscal discipline on themselves to avoid future fiscal disruptions. Together, these two episodes
helped define the fiscal structure of the United States: a strong central government and
independent but fiscally responsible states.
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17.2 SHOULD THE FED TARGET BOTH
INFLATION AND UNEMPLOYMENT? (1 of 2)
Two Debates About Inflation Targeting
DEBATE 1: SHOULD THE FED FOCUS ON ONLY INFLATION?
We have learned that in the long run, monetary policy can influence only the level of prices, not the
level of employment. Proponents of inflation targeting argue that the Fed should have only one
primary goal: controlling inflation.
Before he took over as chairman of the Federal Reserve in 2006, Ben Bernanke was an advocate
for inflation targeting. Bernanke called inflation targeting a policy of constrained discretion. Under
inflation targeting, the Fed could take actions to offset shocks to real output or to the financial
system, but it had to keep its long-run inflation targets in clear view.
However, many economists disagree with the idea of inflation targeting because they strongly object
to the Fed concentrating solely on controlling inflation.
Economists also debate the level for an inflation target. It is very difficult to measure changes in
prices accurately when there is a great deal of technological change occurring in the economy.
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17.2 SHOULD THE FED TARGET BOTH
INFLATION AND UNEMPLOYMENT? (2 of 2)
Two Debates About Inflation Targeting
DEBATE 2: IF THERE WERE AN INFLATION TARGET, WHO WOULD SET IT?
In the United Kingdom, which adopted targeting in 1992, the elected government decides on the
inflation target for the central bank.
In other countries, the central bank has more influence in setting the inflation target.
Under current law, the Fed chairman reports regularly to Congress, but the Fed has considerable
power to use monetary policy to stabilize output as well as to fight inflation as it pleases.
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APPLICATION 2
•
WOULD A POLICY RULE HAVE PREVENTED THE HOUSING BOOM?
APPLYING THE CONCEPTS #2: Did the Federal Reserve cause the housing boom
through excessively loose monetary policy?
•
• John Taylor of Stanford argued that the Fed’s “easy money” policy from mid-2001 through
2004 was responsible for the housing boom.
• The Fed lowered interest rates from 2 percent in 2001 to 1 percent in 2004. Using the Taylor
Principle, he found they should have raised it to 4 percent.
• He showed that housing starts, which are very sensitive to interest rates would have been
much lower and the boom and bust would have been avoided.
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17.3 SHOULD WE TAX CONSUMPTION
RATHER THAN INCOME? (1 of 3)
● Consumption taxes
Taxes based on the consumption, not the income, of individuals.
Two Debates About Consumption Taxation
DEBATE 1: WILL CONSUMPTION TAXES LEAD TO MORE SAVINGS?
There is no question that taxing consumption instead of savings creates an incentive to save.
However, there’s no guarantee the incentive will actually result in more money saved in the
economy.
People will want to take advantage of this incentive and reduce consumption and increase
savings. On the other hand, people will also want to spend more because, with the tax cut, they
are wealthier.
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17.3 SHOULD WE TAX CONSUMPTION
RATHER THAN INCOME? (2 of 3)
Two Debates About Consumption Taxation
DEBATE 2: ARE CONSUMPTION TAXES FAIR?
● Capital gains
Profits investors earn when they sell stocks, bonds, real estate, or other assets.
In practice, moving to a consumption-tax system could have a major impact on the distribution of
income in the economy.
Suppose we simply exempted the returns from savings from the income tax.
This exception would clearly favor wealthy and high-income individuals who save the most and
earn a lot of income in interest, dividends, rents, and capital gains.
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17.3 SHOULD WE TAX CONSUMPTION
RATHER THAN INCOME? (3 of 3)
Two Debates About Consumption Taxation
DEBATE 2: ARE CONSUMPTION TAXES FAIR?
TABLE 17.1 Distribution of Capital Gains and Dividends by Income Class, 2009
Cash Income Level
Share of Capital Gains and Dividends
Less than $40,000
0%
$40,000 to $50,000
0.1
$50,000 to $75,000
0.9
$75,000 to $100,000
1.4
$100,000 to $200,000
8.2
$200,000 to $500,000
19.5
$500,000 to $1,000,000
13.8
Greater than $1,000,000
55.9
SOURCE: Estimates from the Urban-Brookings Tax Policy Center Microsimulation Model,
http://www.taxpolicycenter.org/index.cfm (Accessed May 28, 2012).
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APPLICATION 3
•
IS A VAT IN OUR FUTURE?
APPLYING THE CONCEPTS #3: Can the United States adopt a European-style
value-added tax?
•
• Virtually all developed countries use a value-added tax; a VAT. The United States is a
prominent exception.
• A VAT is essentially a sales tax added at each stage of production. It is embedded and easy
to collect, however it tends to be high; 17.5 percent in the United Kingdom.
• A VAT would be regressive and might impinge on state taxing authority.
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KEY TERMS
Capital gains
Consumption taxes
Monetizing the deficit
Ricardian equivalence
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