Download Fiscal Policy

FIN 30220: Macroeconomic
Analysis
Fiscal Policy: Spending & Taxes
The US Government spent $3.70 Trillion
dollars in 2012. That’s approximately
$12,000 per person!
Put another way,
government spending
is approximately a
quarter of all domestic
expenditures.
GDP = $15.5T
While our government is bigger than some, it is much smaller than others
Government as a % of GDP
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Dissecting the Federal Budget
In 2012, The US Government spent $3.70T
On Budget: $2.939T (80%)
+ Off Budget: $761B (20%)
Total: $3.70T
Mandatory: $2.116T (58%)
Discretionary: $1.344T (36%)
+ Interest: $240B (6%)
Total: $3.70T
By law, the Social Security
System and the US Postal
Service must maintain
separate budgets and, hence,
are “off” the general budget
Determined by Congress on
an annual basis (ex:
Defense)
Determined by existing law
(ex: Social Security,
Medicare)
Source: Office of Management and Budget
Timeline for the budget process
With the help of the office of management and budget (OMB), the president
creates a budget proposal – sent to congress the first week of February
Differences between House/Senate proposals are worked
out in conference committees – joint resolution presented
and voted on
January February
March
April
May
June
July
August September
October
Appropriations bills presented and voted on
Fiscal Year
Begins
With the help of the congressional budget office (CBO), the house and
senate budget committees write their own budget proposals
The US Budget is officially titled a “Resolution of
Congress” – it is not a Bill. So, what difference does it
make?
A resolution, once approved by both houses of
congress, requires no presidential signature Further,
a resolution is not a law and DOES NOT have to be
obeyed!
However, the budget itself does not allow the government to spend
money. It only gives the government the authority to spend money. To
actually spend money, the government must pass an appropriation bill.
That is a law.
Note that authorized spending need not be appropriated in a given year, but
can be carried forward, so actual outlays need not equal budget authority
Defense Appropriations Bill (2012)
Authorized: $700B
Appropriated: $650B
Defense Appropriations Bill (2013)
Authorized: $750B
Appropriated: $800B
$50B of
authorization
remaining
The Government Uses “Baseline Budgeting” with a minimum 5 year cycle
Current
Year
1
Horizon Years
Budget
Year
2
3
4
Anticipated
spending
This is what the
government is currently
spending
Adjusted spending
under the new law
5
Therefore, a government cut is generally not really a cut! Consider the following
example
Defense
Appropriations
Bill
Current
Year
1
Horizon Years
Budget
Year
2
3
4
5
2012
$700B
$750B
(+7%)
$850B
(+13%)
$1,000B
(+17%)
$1,200B
(+20%)
2013
$750B
$800B
(+6%)
$900B
(+12%)
$1,150B
(+16%)
$1,350B
(+17%)
In government lingo, this would be called a $50B( 6%) cut to the defense
budget!!
Financing The Government
“In this world, nothing is
certain, but death and taxes”
Income Tax
Alternative Minimum Tax
2012
Estate Tax
Individual Income Taxes: $1,145B
Corporate Income Taxes: $327B
+ Social Insurance Taxes: $927B
Other Revenues:
$210B
Total: $2.609T
On-Budget: $1.949T
Off-Budget: $660B
Off –Budget is essentially social
security taxes
Who Pays Income Taxes?
Quintile
Average
Income
% of Total
Income
% of Total
Taxes
Bottom 20%
$13,000
3%
<1%
2nd 20%
$30,000
8%
2%
Middle 20%
$49,000
14%
13%
4th 20%
$72,000
23%
25%
Top 20%
$147,000
50%
60%
Top 5%
$254,000
21%
40%
Top 1%
$1,000,000
15%
30%
US Income Tax Rates (Single Filers)
Taxable Income
Tax Rate
$0 - $7,150
10%
$7,151 - $29,050
15%
$29,051 - $70,350
25%
$70,351 - $146,750
28%
$146,751 - $319,100
33%
$319,101 +
35%
Note: These Tax
Brackets are annually
indexed for inflation
Standard Deduction: $5,000
+ Personal Exemption: $3,200
$8,200
Taxable Income = Gross Income - $8,200
Taxable Income
Tax Rate
$0 - $7,150
10%
$7,151 - $29,050
15%
$29,051 - $70,350
25%
$70,351 - $146,750
28%
$146,751 - $319,100
33%
$319,101 +
35%
The Tax Brackets
indicate marginal tax
rates – i.e. the
percentage of each
additional dollar
earned that gets paid
in taxes
Suppose that you earn $85,000 per year (single filer)
Gross Income:
-
$85,000
Standard Deduction: $5,000
Personal Exemption: $3,200
Taxable Income
$76,800
Your “Average Rate” =
$7,150 * .10 =
$715
$21,900 * .15 =
$3,285
$41,300 * .25 =
$10,325
+ $6,450 * .28 =
Tax Bill =
$16,131
X 100 = 19%
$85,000
$1,806
$16,131
The Government must make up the difference between taxes collected
and spending on current programs by borrowing
2012 Expenditures
2012 Revenues
On-Budget: $2.939T
+ Off-Budget: $761B
2012 Surplus/Deficit
On Budget: $1.949T
+ Off Budget: $660B
Total: $3.70T
On-Budget: - $990
+ Off-Budget: - $101
Total: $2.609T
Total: - $1.091T
This is the official deficit that’s
reported
In 2012, the government spent
$2.939T on programs other than
social security
In 2012, The Social Security
Administration spent $761B on
current benefits
$1.949T Was paid for with current taxes
$990B was borrowed from the public
$660B Was paid for with current taxes
$101B was borrowed from the public
The US budget was essentially balanced until the early 1970’s
Deficit/Surplus (Millions of Current Dollars)
Total Debt outstanding represents the cumulative effect of past deficits
(stocks vs. flows)
What really matters is debt relative to ability to pay (GDP) While the US
economy grew at an average rate of 6% (Nominal), growth of the debt
has changed dramatically
Debt as a Percentage of GDP
Debt growth at
2.5% per year
Debt growth at
8.5% per year
Can we sustain our current policies?
Debt is manageable as long as it grows at a slower pace than
income (i.e. we can grow out if it!)
Current Deficit
+
Total Debt
Interest Rate

GPD Growth
Growth of
Debt
$500B
+ .015
$18T
Treasury Rate
= .043
Our economy would need to grow at
4.2% (nominal) per year to sustain our
current projected deficits (i.e. maintain
a constant Debt/GDP ratio).
Unfortuntnately, we are only growing at
3.8%
Can we sustain our current policies?
Alternatively, let’s calculate the deficit that is sustainable
(Debt/GDP is constant)
Deficit

GPD
Total Debt
$18T
Growth
3.8%

Nominal
Interest Rate
1.5%
Given the above numbers, we can sustain a $400B
Deficit
Two arguments for Fiscal Policy
Efficiency
Equity
Efficiency refers to the
collective well being of an
economy.
Equity refers to the distribution
of well being across individual
in an economy.
Can we use fiscal policy to
increase aggregate income? (i.e.
increase total welfare.)
Can we use
fiscal policy to
redistribute
income in a
“fair” way?
Let’s suppose that the economy is currently at full employment (the
unemployment rate is 5%) and GDP equals $15T. Government expenditures
are currently $3T.
r
FE
Y  C  I G
LM
$15T
$12T
$3T
8%
IS
$15T
y
Note: None of the numbers here are calculated
Now, suppose that uncertainty about the future causes consumers and
businesses to cut their planned expenditures by 10%
r
Y  C  I G
FE
LM
$1.2T
$10.8T
8%
$3T
$13.8T
4%
IS
$15T
1 .2
 8%
15
As 8% output gap would
be associated with a
8/2.5 = 3.2% rise in
unemployment
y
Okun’s Law: A 1% rise in
unemployment translates to a
2.5% drop in GDP
The immediate impact would be a drop in the interest rate and production
r
FE
LM
$1.2T
8%
6%
4%
IS
$14.4T $15T
.6
 4%
15
y
As 4% output gap would
be associated with a
4/2.5 = 1.6% rise in
unemployment
To get back to full employment, we need the interest rate to drop even farther…
The longer term impact would be an additional drop in the interest rate and a
decrease in prices (i.e. deflation)
r
FE
LM
8%
6%
4%
IS
$15T
y
Now we are back to full employment…but after a long, painful recession and
prolonged deflation
What if the government could move the IS curve back to the right by $1.2T.
The could return the economy to full employment…
r
FE
We should increase
government spending by
$1.2T, right?
LM
$1.2T
8%
IS
$15T
y
Y  C  I G
We have a drop in
demand of $1.2T
“If I Had a Hammer…”
Suppose that the government pays $100 for a
new hammer from the local hardware store
Now, suppose that the hardware store
owner takes his $100 in new income and
spends $95 (95%) at the grocery store
Now, suppose that the grocer owner takes
his $95 in new income and spends $90.25
(95%) at the local tavern…..
This will
continue to
ripple out…
“If I Had a Hammer…”
Lets add up all the increases in income due
to the initial government purchase of a $100
hammer
Hardware Store:
$100
Grocer:
$95
Tavern:
$90.25
--------
$85.74
--------
$81.45
Total:
The initial $100 increase in
government spending raised total
income by $2,000 (a factor of 20)
1
1
m

 20
1  MPC 1  .95
$2,000
Marginal Propensity to Consume
If the government bought $60B worth of hammers, that should do the trick!
Before
FE
r
Y  C  I G
LM
$10.8T
$1.2T
$3T
8%
IS
$13.8T
$15T
y
After
Y  C  I G
$11.94T
So, with a MPC of 95%
m
1
1

 20
1  MPC 1  .95
$1.2T
 $60 B
20
$3.06T
Let’s take the US Economy….we saw a rise in unemployment from
5% to 10% in this last recession.
FE
r
Multiply by 2.5
(Okun’s law)
LM
$1.75T
5% cyclical
unemployment
IS
$12.25T
$14T
y
12.5%
drop in
output
$14T*(.125) = $1.75T
The personal savings rate
at the time was around 4%
1
1
m

 25
1  MPC 1  .96
$1.75T
 $70 B
25
But the government stimulus
plan was over $700B and
nothing happened…
However, we need to be careful here….
m
1
1  MPC
We need the marginal
propensity to consume, using
the savings rate, we really have
the average propensity to
consume
It could be
C  .93Y
C
Here, we have (at Y = $40,000)
$37, 200
APC 
$40, 000
Y
37, 200
 93%
40, 000
Average propensity to
consume
1
m
 14
1  .93
However, we need to be careful here….
m
1
1  MPC
We need the marginal
propensity to consume, using
the savings rate, we really have
the average propensity to
consume
Or, it could be
C  20, 000  .43Y
C
C
Here, we have (at Y = $40,000)
$37, 200
APC 
$20, 000
$40, 000
Y
37, 200
 93%
40, 000
MPC  43%
Average propensity to
consume
1
m
 1.75
1  .43
“If I Had a Hammer…”
Lets add up all the increases in income due
to the initial government purchase of a $100
hammer
Hardware Store:
$100
Grocer:
$95
Tavern:
$90.25
--------
$85.74
--------
$81.45
Total:
The initial $100 increase in
government spending raised total
income by $2,000 (a factor of 20)
1
1
m

 20
1  MPC 1  .95
$2,000
Marginal Propensity to Consume
What’s wrong with this argument?
“If I Had a Hammer…”
The government needs to pay for the
hammer. Lets assume that the
government taxes the local hardware
store and then uses the $100 to buy the
hammer. How does this change things?
Oops…wrong
hammer!!
What does the government do with the hammer?
Case #1: The government gives the hammer to the grocer across the street
(transfer)
Case #2: The government throws the hammer into the ocean (wasteful
spending)
Case #3: Derek Jeter signs the hammer (raising its value to $200) and gives it
back to the hardware store (productive spending)
Public Goods have two distinct characteristics:
Non-Rivaled: Anyone can use a public good without affecting its use by
others (zero marginal cost)
Non-Excludable: Its either very difficult or very costly to charge for usage
of a public good
Suppose that there are 10,000 people living in Springfield. Each resident is willing
to pay up to $.10 to have a drinking fountain in town. The fountain would cost
$500 to build.
It would be difficult to charge people to use the fountain.
Therefore, the private sector probably wouldn’t supply it.
Here’s a chance for the government to step in and save the
day!
Why shouldn’t the government supply private goods?
Consider the Jones’: The Jones’ live in Buffalo NY. Mr. Jones works 40 hours per
week at a local factory. They have an annual household income of $50,000.
Jones’ Family Budget
Income:
$50,000
Taxes:
$10,000
$40,000
Consumption:
$30,000
Savings:
$10,000
Suppose that Obama announces that they will
spend $200B on a bridge that will go halfway to
Hawaii (i.e. the bridge has a final value of $0) .
Each household will be taxed $1,000 to pay for
this project.
Remember…this is
determined by the
Jones’ wealth – not
just current income
How should this spending plan influence the Jones’?
Jones’ Family Budget
Income:
$50,000
Taxes:
$11,000
$39,000
Consumption:
$30,000
Savings:
$9,000
Savings drops by $1000
r
S
r*
I  G  T 
S *, I *
S, I
Tax Increase of $1,000
This one time project should
have a negligible impact on
the Jones’ wealth and, hence
a negligible impact on
consumption
So, the government raises spending by $1,000 per person, and household
consumption is left unchanged (household savings drops by $1,000)
$1,000
r
$1,000
Y  C  I G
r
r
S
IS
y
r*
I  G  T 
S *, I *
S, I
The IS curve moves to the right by
$1,000 – i.e. the government
multiplier equals 1
Suppose that the government decides to spend $1,000 wastefully every
year…
$1,000
Y  C  I G
r
$1,000
r
r
S
IS
r*
y
I  G  T 
S *, I *
Households adjust to the
permanently lower income by
spending less
S, I
The IS curve moves to the right by
$0– i.e. the government multiplier
equals 0!
Now, consider another spending plan…Obama decides to nationalize the
cable industry. Everyone will receive government provided cable television.
They can provide this service for $500 per year.
Jones’ Family Budget
Income:
$50,000
Taxes:
$10,000
$40,000
Consumption:
$30,000
Savings:
$10,000
Rent: $15,000
Food: $10,000
Transportation: $4,000
Cable TV: $1,000
How will this spending plan
affect the Jones family?
How should this spending plan influence the Jones’?
Jones’ Family Budget
Income:
$50,000
Taxes:
$10,500
$39,500
Consumption:
$29,000
Savings:
$10,000
Extra Income:
r
Tax Increase of $500
Rent: $15,000
Food: $10,000
Transportation: $4,000
Cable TV: $0
$500
S
r*
I  G  T 
S *, I *
S, I
If this is a one time
increase in income,
savings goes up . If it
is permanent,
consumption goes up
by $500
Suppose that this one a one year program only….
$500
Y  C  I G
r
$500
$1,000
r
r
$500
S
IS
r*
y
I  G  T 
S *, I *
Households put the income gain
into savings
S, I
The IS curve moves to the left by
$500– i.e. the government
multiplier is negative!
If this were a permanent program, households would feel free to spend
the $500 savings.
$500
Y  C  I G
r
$500
r
r
S
IS
r*
y
I  G  T 
S *, I *
Households put the income gain
into consumption
S, I
The IS curve doesn’t move…again,
a government multiplier of zero!!
The Simpson's live next door to the Jones’. Homer Simpson works at the local power
plant. He earns $20,000 per year.
Jones’ Family Budget
Simpson’s Family Budget
Income:
$50,000
Income:
$20,000
Taxes:
$10,000
Taxes:
$2,000
$18,000
$40,000
Consumption:
$30,000
Consumption:
$15,000
Savings:
$10,000
Savings:
$3,000
Suppose that the government offers a temporary $1,000 tax credit to lower income
households. The program will cost the average upper income household $1,000
Suppose that the government offers a temporary $1,000 tax credit to lower income
households. The program will cost the average upper income household $1,000
Jones’ Family Budget
Income:
$50,000
Taxes:
$11,000
Simpson’s Family Budget
$1,000
Income:
$20,000
Taxes:
$1,000
$39,000
$19,000
Consumption:
$30,000
Consumption:
$15,000
Savings:
$9,000
Savings:
$4,000
The Jones’ lower their savings to
finance their higher tax bill
The Simpson’s put the tax credit in the
bank.
Suppose that the government offers a temporary $1,000 tax credit to lower income
households. The program will cost the average upper income household $1,000
S
r
r*
I  G  T 
S *, I *
S
r
S, I
r*
I  G  T 
S *, I *
In principle, this should cancel out in the aggregate!
S, I
For transfers to make a difference at the aggregate level, we need different preferences
(i.e. different marginal propensities to consume)
$500
S
r
I  G  T 
MPC = .5
S
r
r*
S *, I *
$100
S, I
r*
I  G  T 
S *, I *
MPC = .9
S, I
So, the government raises spending by $1,000 per person, and household
consumption increases by $400 (household savings drops by $400)
r
+$900
$400
Y  C J  CS  I  G
-$500
r
$400
S
IS
r*
I  G  T 
S *, I *
S, I
The IS curve moves right!
y
Lets look at a breakdown of Mr. Jones tax liability
Income:
$50,000
Taxes:
$10,000
Mr. Jones taxable income of
$45,000 put him in the 30%
tax bracket
Tax Code
Income
Tax Rate
Tax Paid
Taxable Income
Tax Rate
$10,000
15%
$1,500
$0 - $10,000
15%
$20,000
20%
$4,000
$10,000 - $30,000
20%
$15,000
30%
$4,500
$30,000 - $50,000
30%
Total:
$30,000 +
35%
Standard Deduction = $5,000
$10,000
Mr. Jones’ average tax rate is 20%
Suppose the government passes a “middle class tax cut”. The top two brackets are
reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to
$2,000. How does this impact Mr. Jones?
Income:
$50,000
Taxes:
$10,000
Mr. Jones taxable income of
$48,000 put him in the 25%
tax bracket
Tax Code
Income
Tax Rate
Tax Paid
Taxable Income
Tax Rate
$10,000
15%
$1,500
$0 - $10,000
15%
$20,000
20%
$4,000
$10,000 - $30,000
20%
$18,000
25%
$4,500
$30,000 - $50,000
25%
Total:
$30,000 +
30%
Standard Deduction = $2,000
$10,000
Mr. Jones’ average tax
rate is still 20%
Suppose the government passes a “upper class tax cut”. The top two brackets are
reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to
$2,000. How does this impact Mr. Jones?
Old Tax Code
Income
Tax Rate
Tax Paid
Income
Tax Rate
Tax Paid
$10,000
15%
$1,500
$10,000
15%
$1,500
$20,000
20%
$4,000
$20,000
20%
$4,000
$15,000
30%
$4,500
$18,000
25%
$4,500
Total:
w
p
 w
 
 p
New Tax Code
$10,000
Total:
r
l
s
*
ld
l
$10,000
FE
A drop in Mr. Jones’s
marginal tax rate
increases the incentive to
work – labor supply
increases. This should
raise production
y
A cut in marginal tax rates that leaves average rates unchanged raises the
economy’s capacity as employment rises. But what about expenditures?
r
S
r
FE
LM
r*
r*
S *, I *
A tax cut will increase investment (because higher
employment raises the productivity of capital)
IS
y*
Capacity output
increases from
the tax cut
I  G  T 
S, I
y
r
r
IS
y
Alternatively, suppose the government passes a “lower income class tax cut”. The bottom
two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is
kept at $5,000. How does this impact Mr. Jones?
Income:
$50,000
Taxes:
$8,500
Mr. Jones taxable income of
$45,000 put him in the 30%
tax bracket
Tax Code
Income
Tax Rate
Tax Paid
Taxable Income
Tax Rate
$10,000
10%
$1,000
$0 - $10,000
10%
$20,000
15%
$3,000
$10,000 - $30,000
15%
$15,000
30%
$4,500
$30,000 - $50,000
30%
Total:
$30,000 +
35%
Standard Deduction = $5,000
$8,500
Mr. Jones’ average tax
falls to 17%
Alternatively, suppose the government passes a “lower income class tax cut”. The bottom
two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is
kept at $5,000. How does this impact Mr. Jones?
Old Tax Code
Income
Tax Rate
Tax Paid
Income
Tax Rate
Tax Paid
$10,000
15%
$1,500
$10,000
10%
$1,000
$20,000
20%
$4,000
$20,000
15%
$3,000
$15,000
30%
$4,500
$15,000
30%
$4,500
Total:
w
p
 w
 
 p
New Tax Code
$10,000
l
Total:
w
p
s
$8,500
ls
*
ld
l
If households are rational and forward looking,
they should recognize that the tax cut will need to
be repaid and thus will not feel better off…
ld
l
If households are not rational and forward looking,
they will feel better off and work less
A tax cut will raise the deficit and increase government borrowing, but what
about household savings?
r
S
r*
S *, I *
If households are rational and forward
looking, they should recognize that the tax
cut will need to be repaid and thus
increase savings… expenditures (and, the
IS curve are unaffected)
I  G  T 
S, I
r
S
If households are not rational and forward
looking, they will increase expenditures
(and, the IS curve shifts right)
r*
S *, I *
I  G  T 
S, I
A cut in average tax rates that leaves marginal rates unchanged actually lowers
the economy’s capacity as employment falls while potentially raising
expenditures
r
r
S
FE
LM
r*
r*
I  G  T 
S *, I *
S, I
IS
y*
Capacity output
increases from
the tax cut
y
If households are not rational and
forward looking, they will increase
expenditures (and, the IS curve shifts
right)
Government Spending
If the government invests in purely wasteful spending, the multiplier
effect is the largest, but should that justify spending money on stupid
projects?
Effective spending (say, on public goods) could actually lower
employment and output (i.e. a negative multiplier), but don’t we want our
government spending our money wisely?
Transfers could give the economy a boost without wasting any
resources. The bigger issue with transfers is economic equity
Taxes
Taxes are an effective stimulus only if you can change marginal
rates while leaving effective rates unchanged.