Download Parkin-Bade Chapter 24

Ch. 14: Fiscal Policy
• Federal budget process and recent history of outlays,
tax revenues, deficits, and debts
• Supply-Side Economics
• Controversies on effects of deficits on investment,
saving, and economic growth
• Redistribution of benefits and costs across generations
• Fiscal policy as a stabilization tool
The Federal Budget and Fiscal Policy
 Federal budget
• annual statement of the federal government’s outlays and tax
revenues.
• Two purposes
o finance the activities of the federal government
o achieve macroeconomic objectives
 Fiscal policy
• the use of the federal budget to achieve macroeconomic
objectives
• Employment Act of 1946
it is the continuing policy and responsibility of the Federal
Government to use all practicable means . . . to coordinate and
utilize all its plans, functions, and resources . . . to promote
maximum employment, production, and purchasing power.
Timeline for 2007 Budget
Fiscal Policy
 The Council of Economic Advisers
• monitors the economy
• keeps the President and the public well informed
about the current state of the economy
• forecasts of where it is heading.
• source of data that informs the budget-making
process.
 Congressional Budget Office
• Forecasts effects of legislative changes on budget and
economy
Source of Revenues
Revenues
Composition of Outlays
Federal Deficits and Public Debt
 Budgett = revenuet –outlayst
• if Budgett > 0  budget surplus
• if Budgett < 0  budget deficit
 Debtt = Debtt-1 - budgett-1
• Budget deficits increase debt
• Budget surpluses decrease debt
Revenues and Outlays
The U.S. Government Budget in Global Perspective
State and Local Budgets
 In 2005, when federal government outlays were about
$2,500 billion, state and local outlays were almost
$1,700 billion.
 Most state expenditures were on public schools,
colleges, and universities ($550 billion); local police and
fire services; and roads.
 Greatest source of state revenue: income & sales taxes
 Greatest source of local tax revenue: property & sales
taxes
 Many states (including Ohio) have a balanced budget
amendment.
Supply-Side Economics
 Fiscal policy aimed at increasing LAS
• Income taxes affect LAS by affecting labor supply.
• Higher income taxes reduce labor supply & reduce
LAS
• “Supply-siders” argue for low marginal tax rates.
 Graph the effect of an increase in income tax rate on
•
•
•
•
before-tax real wage rate, after-tax real wage rate.
Tax-wedge
Equilibrium employment
LAS
Effect of an increase in income tax rate
Tax Wedge Comparisons
Federal Income Tax Marginal Rates: 2007
Top Marginal Tax Rates
Source: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=213
Historical average tax rates in U.S.
by Income Quintile: Income Tax Only
.: http://www.cbo.gov/doc.cfm?index=6133&type=0
Source:
Includes individual income tax only
Share of Federal Income Taxes Paid by Quintile
.:
Source: http://www.cbo.gov/doc.cfm?index=6133&type=0
Includes individual income tax only
The Supply-Side: The Laffer Curve.
Tax Revenue
Tax Rates
Laffer Curve and Capital Gains Tax
Source: http://time-blog.com/curious_capitalist/2008/01/do_capital_gains_tax_cuts_incr.html
The Supply-Side: Investment and Saving
 GDP = C + I + G + (X – M)
 GDP = C + S + T
 I + G + (X – M) = S + T
I = S + (T – G) + (M – X)
Private saving PS = S + (M – X)
Government Saving GS=T-G
 I = PS + GS
The Supply-Side: Investment and Saving
The Supply-Side: Investment and Saving
 Fiscal policy influences investment and saving in
two ways:
• Taxes affect the incentive to save and change the
supply of loanable funds.
• Government saving is a component of total saving
and the supply of loanable funds.
The Supply-Side: Investment and Saving
 A tax on capital
income decreases
the supply
of loanable funds
 a tax wedge is
driven between the
interest rate and the
after-tax interest
rate
 Investment and
saving decrease.
The Supply-Side: Investment and Saving
 Ricardo-Barro Equivalence
• In above diagram, it is assumed that government
budget does not shift PSLF curve.
• Ricardo-Barro:
o Larger deficits cause households to increase
savings in order to cover future tax increases.
o Net effect of larger deficit on SLF curve is zero
because PSLF curve shifts right.
o No effect on investment or interest rates
o All increases in deficits are offset by increased
saving (decreased consumption).
Generational Effects of Fiscal Policy
• Generational accounting is an accounting system
that compares the present value of lifetime tax
burden with the benefits of each generation.
• Is the budget deficit a burden on future generations?
• Is the deficit in the Social Security fund a burden?
• Does it matter who owns the bonds that the
government sells to finance its deficit?
Generational Effects of Fiscal Policy
 Generational Accounting and Present Value
• Taxes are paid by people with jobs. Social security
benefits are paid to people after they retire.
• To compare the value of an amount of money at one
date (working years) with that at a later date
(retirement years), we use the concept of present
value.
Generational Effects of Fiscal Policy
 The Social Security Time Bomb
• Using generational accounting and present values,
economists have found that the federal government is
facing a Social Security time bomb!
• In 2008, the first of the baby boomers will start
collecting Social Security pensions and in 2011, they
will become eligible for Medicare benefits.
• By 2030, all the baby boomers will have retired and,
compared to 2006, the population supported by Social
Security will have doubled.
Generational Effects of Fiscal Policy
 Under the existing Social Security laws, the federal
government has an obligation to pay pensions and
Medicare benefits on an already declared scale.
 Gokhale and Smetters estimated that the fiscal
imbalance in Social Security / Medicare was $45
trillion in 2003—4 times the value of total production
in 2003 ($11 trillion).
Generational Effects of Fiscal Policy
 Generational imbalance
• division of the fiscal
imbalance between the
current and future
generations, assuming
that the current
generation will enjoy the
existing levels of taxes
and benefits.
• The bars show the scale
of the fiscal imbalance.
Generational Effects of Fiscal Policy
 International Debt
• In June 2006, the United States had a net debt to the
rest of the world of $5.2 trillion.
• Of that debt, $2.2 trillion was U.S. government debt.
• Total U.S. government debt is $4.1 trillion.
• More than half of the outstanding government debt is
held by foreigners.
Stabilizing the Business Cycle
 Discretionary fiscal policy
• action that is initiated by an act of Congress.
 Automatic fiscal policy (Auto stabilizers)
• fiscal policy triggered by the state of the economy.
Stabilizing the Business Cycle
 Discretionary Fiscal
Stabilization
• An increase in
government
expenditure or a
tax cut increases
aggregate
demand.
• The “multiplier
process”
increases
aggregate
demand further.
Stabilizing the Business Cycle
• A decrease in
government
expenditure or a tax
increase decreases
aggregate demand.
• The multiplier
process decreases
aggregate demand
further.
Stabilizing the Business Cycle
 Limitations of Discretionary Fiscal Policy
• Recognition lag
o time it takes to figure out that fiscal policy action is
needed.
o Law-making lag
– time it takes Congress to pass the laws needed to
change taxes or spending.
o Impact lag
– time it takes from passing a tax or spending change to its
effect on real GDP being felt.
Stabilizing the Business Cycle
 Automatic Stabilizers
• mechanisms that stabilize real GDP without explicit
action by the government.
• Taxes that rise and fall with GDP taxes and needstested spending are automatic stabilizers.
• When real GDP decreases in a recession
• wages and profits fall, so taxes fall
• Needs-tested spending rises
• Budget deficit grows (surplus shrinks)
The Budget and the Business Cycle
 Cyclical and Structural Balances
• The structural surplus or deficit
• the surplus or deficit that would occur if the
economy were at full employment and real GDP
were equal to potential GDP.
• The cyclical surplus or deficit
• the actual surplus or deficit minus the structural
surplus or deficit;
• the surplus or deficit that occurs purely because
real GDP does not equal potential GDP.
Stabilizing the Business Cycle