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CH. 15: FISCAL POLICY • Federal budget process and the recent history of expenditures, taxes, deficits, and debt • Supply-side effects of fiscal policy on employment and potential GDP • Effects of deficits on saving, investment, and economic growth • Fiscal policy’s ability to redistribute benefits and costs across generations • Fiscal policy and stabilization. Elements of Fiscal Policy • Federal budget – annual statement of the federal government’s expenditures and tax revenues. • Fiscal policy – use of the federal budget to achieve macroeconomic objectives • Employment Act of 1946 – committed the government to work toward “maximum employment, production, and purchasing power.” • Council of Economic Advisers – monitors the economy and advises the Balancing Acts on Capitol Hill – In 2004, the federal government planned • taxes of 17.3 cents per dollar earned. • spending of 20 cents per dollar earned. • deficit of almost 3 cents per dollar earned. – For most of the 1980s and 1990s, the government ran deficits. – National debt is now about $13,000 per person. Budget information is from www.publicagenda.org Federal spending has grown Spending as a % of GDP has been stable ..new records on $ value of deficits …not a record as % of GDP ..new records on level of debt debtt= debtt-1+ deficitt-1 ..not a record as % of GDP More history from textbook Who holds the debt? Top tax rate has dropped over time U.S. is a relatively low tax country State and Local Budgets • In 2002, when the federal government spent $2,000 billion, state and local governments spent almost $1,900 billion, mostly on education, protective services, and roads. • State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions. Supply Side Effects of Fiscal Policy • A tax on labor income creates a tax wedge • Taxes on consumption such as sales or value-added taxes add to the tax wedge indirectly. The Supply Side: Employment and Potential GDP • Does the Tax Wedge Matter? – Potential GDP per person in France is 31 percent below that in the United States – According to research by Edward Prescott, the entire difference is explained by the larger tax wedge in France. U.S. taxes in international perspective The Supply Side: The Laffer Curve • An increase in the tax rate – decreases employment. – encourages tax evasion (both legal and illegal) – could cause tax revenue to rise or fall. The Supply Side: Investment, Saving, and Economic Growth • The Sources of Investment Finance • GDP = C + I + G + X – M. • and • GDP = C + S + T. • From these two equations, – I = S + T – G + M – X. The Supply Side: Inv & Saving – I =S+ M–X+T–G – = PS + GS – PS: private saving • S: Private domestic saving • (M-X) Foreign saving (i.e. borrowing from foreign co’s) – GS: government saving • Taxes-Government Spending-Transfers The Supply Side: Inv & Saving • Sources of funds for investment: – Foreign sources have become larger. – The government deficit has become a drain on investment. The Supply Side: Inv & Saving • Fiscal policy can influence investment in two ways: • Taxes affect the incentive to save or invest • Government saving—the budget surplus or deficit—is part of total saving The Supply Side: Inv & Saving – An income tax drives a wedge between the before-tax and after-tax interest rate and decreases saving supply. Interest rate Saving Supply Investment Demand The Supply Side: Inv & Saving – Increased taxes on business profits reduce investment demand. Interest rate Saving Supply Investment Demand Policies to promote Investment • Encourage savings – Pensions – IRAs – MSAs – Capital gains / dividends tax • Encourage Investment – Business tax rates – Investment tax credits – Accelerated depreciation Policies to promote Investment • Government Saving – A government budget deficit is a decrease in total saving. – crowding-out occurs if a government budget deficit decrease investment is called. Crowding Out • The Ricardo-Barro effect – an increase in private saving by an amount equal to the government budget deficit. – occurs if households recognize that a government budget deficit must be paid for by higher taxes in the future. – Ricardian Equivalence: Deficit has no effect on interest rates or investment. Stabilizing the Business Cycle • Fiscal policy may seek to stabilize the business cycle work by changing aggregate demand. – Discretionary fiscal policy is a policy action that is initiated by an act of Congress. – Automatic fiscal policy (auto. Stabilizers) is a change in fiscal policy triggered by the state of the economy. Stabilizing the Business Cycle – Multiplier effects – Government spending multiplier • An increase in government purchases increases aggregate income, which induces additional consumption expenditure. – The tax multiplier is the magnification effect of a change in taxes on AD. • An increase in taxes decreases disposable income, which decreases consumption expenditure and decreases AD and real GDP. Stabilizing the Business Cycle • Limitations of Discretionary Fiscal Policy – The use of discretionary fiscal policy is hampered by three time lags: • Recognition lag • Law making lag • Impact lag Stabilizing the Business Cycle • Automatic Stabilizers – Mechanisms that stabilize real GDP without explicit action by the government. – Income taxes and transfer payments – Government’s budget deficit also varies with this cycle. • In a recession, taxes fall, transfer payments rise, and the deficit grows • In an expansion, taxes rise, transfers fall, and deficit shrinks. The budget and the business cycle The budget and the business cycle – Structural surplus or deficit • surplus or deficit that would occur if the economy were at full employment and real GDP were equal to potential GDP. – Cyclical surplus or deficit • actual surplus or deficit minus the structural surplus or deficit; • it is the surplus or deficit that occurs purely because real GDP does not equal potential GDP.