Download Government Spending

Fiscal Policy
Government spending & taxes
Government Spending
• Total government spending in
the US is approximately $3.5T.
($2.5T Federal, $1T
State/Local) – that’s around
$10,000 per person!
Government Spending
• Total government spending in
the US is approximately $3.5T.
($2.5T Federal, $1T
State/Local) – that’s around
$10,000 per person!
• Total government as a
percentage of the economy is
around 35%.
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Government Spending
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• Total government spending in
the US is approximately $3.5T.
($2.5T Federal, $1T
State/Local) – that’s around
$10,000 per person!
• Total government as a
percentage of the economy is
around 35%.
• Government spending grows
approximately 5% per year
Government Spending
• For budget procedures, government spending can
be classified in two categories:
– Discretionary (35%)
– Mandatory (65%)
• The government follows baseline budgeting
– Unless otherwise stated, baseline discretionary
spending grows at the rate of inflation
– Baseline mandatory spending growth is dictated by the
spending rules
The Federal Budget:2003
Budget Item
Amount
(Billions)
Percentage
Average
Growth
Defense
$376
18%
7%
Other Discretionary
$416
19%
3%
Social Security
$474
22%
5%
Medicare/Medicaid
$408
19%
10%
Other Mandatory
$305
15%
5%
Interest on Debt
$161
7%
4%
Total
$2,140
100%
5%
Financing government spending
• How does the government pay for its
spending?
Financing government spending
• How does the government pay for its
spending?
– Taxes
– Borrowing (selling bonds)
– Printing money (seignorage)
Federal Taxes: 2003
Source
Amount (Billions) Percentage
Income Taxes
$849
46%
Corporate Taxes $143
8%
Payroll Tax
$726
40%
Estate Taxes
$20
1%
Miscellaneous
$98
5%
Total
$1, 836
100%
US Income Tax Rates
Bracket
Old Rate
New Rate
$0 - $6,000
15%
10%
$6,000 - $27,250
15%
15%
$27,251 - $67,550
28%
25%
$67,551 - $141,600
31%
28%
$141,601 - $307,300
36%
33%
$307,301 +
39.6%
35%
Who Pays Income Taxes?
Quintile
Bottom 20%
Average
Income
$13,000
% of Total
Income
3%
% of Total
Taxes
<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%
Government Borrowing
• In 2003, the federal government spent an estimated $2.14T
while tax revenues were $1.853T
Government Borrowing
• In 2003, the federal government spent an estimated $2.14T
while tax revenues were $1.853T
$2.14 T: Outlays
- $1.836: Taxes
$ 304 B Deficit
Government Deficits
• In 2003, the federal government spent an estimated $2.14T
while tax revenues were $1.853T
$2.14 T: Outlays
- $1.836: Taxes
$ 304 B Deficit
• Of greater importance is the primary deficit. This
represents spending on current programs in excess of
current taxes
– $304B = $143 (Primary Deficit) + $161 (Interest on Debt)
Government Borrowing
• The deficit represents new government borrowing (new
government securities). This gets added on to previous
borrowing (existing government securities) to make up the
total – the government debt
Government Borrowing
• The deficit represents new government borrowing (new
government securities). This gets added on to previous
borrowing (existing government securities) to make up the
total – the government debt
• Currently, government debt held by the public is
approximately $3.9T (approximately $15,000 per person).
US Deficits/Debt
4000
300000
3500
200000
3000
100000
2500
0
2000
-100000
1500
1999
1994
1989
1984
1979
1974
1969
1964
-400000
1959
0
1954
-300000
1949
500
1944
-200000
1939
1000
Debt
Deficit
Deficits/Debt
• The absolute size of the US debt is
irrelevant. What matters is the size of the
debt relative to the size of the economy.
Deficits/Debt
• The absolute size of the US debt is
irrelevant. What matters is the size of the
debt relative to the size of the economy.
• Currently, the debt to GDP ratio is around
35% and has been steadily falling since
WWII.
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
1964
1961
1958
1955
1952
1949
1946
Debt/GDP Ratio
1.2
1
0.8
0.6
0.4
0.2
0
Sustainable deficits
• If GDP is growing, it is possible to run a deficit
without increasing the debt to GDP ratio.
Sustainable deficits
• If GDP is growing, it is possible to run a deficit
without increasing the debt to GDP ratio
Growth of Debt/DGP = Primary Deficit/Total Debt + interest rate –
growth of nominal income
For example, our current primary deficit is $143B. Assuming a 4%
interest rate and a 2% rate of economic growth
Growth of Debt/GDP = ($143/$3900) + 4% - 2% = 2.04%
Seignorage Revenue
• The government also earns “revenue” by printing money. This is done
by printing money and using that currency to buy back government
debt.
Seignorage Revenue
• The government also earns “revenue” by printing money. This is done
by printing money and using that currency to buy back government
debt.
• For example, suppose that the government uses $100M worth of newly
printed currency to buy back $100M worth of government debt.
Assuming that there was initially $1B of currency in circulation, we
know that eventually this will create a 10% price increase – thus
reducing the purchasing power of every dollar in circulation by 10%.
Seignorage Revenue = (inflation Rate)*(Monetary Base)
• The federal government currently collects ($700B)(2%) = $14B in
seignorage revenue annually.
Analysis of government
expenditures
• From an analysis point of view, there are
two types of government spending:
Analysis of government
expenditures
• From an analysis point of view, there are
two types of government spending:
– Transfers (70%)
– Government purchases (30%)
Analysis of government
expenditures
• From an analysis point of view, there are
two types of government spending:
– Transfers (70%)
– Government purchases (30%)
• The results also depend on the presence of
nominal rigidities (i.e., classical vs.
Keynesian)
Transfers
• For simplicity, assume that all government expenditures
are financed by current tax revenues – (G-T) = 0
Transfers
• For simplicity, assume that all government expenditures
are financed by current tax revenues – (G-T) = 0
• By definition, transfer payments neither create nor destroy
income, they only redistribute income. Therefore, they
create both a positive income effect (whoever receives the
benefits) and a negative income effect (whoever is taxed)
Transfers
Group
Taxed
Beneficiary
Net
Labor
Supply
Consumption Savings
Transfers
Group
Labor
Supply
Taxed
Increase
Beneficiary
Decrease
Net
?
Consumption Savings
Transfers
Group
Labor
Supply
Consumption Savings
Taxed
Increase
Decrease
Decrease
Beneficiary
Decrease
Increase
Increase
Net
?
?
?
Transfers
• In principle, anything can happen in response to a transfer
payment. Everything depends on the reaction of the two
groups. However, empirically lower income individuals
have a much higher marginal propensity to consume
(around .9) than to wealthier individuals (around .3)
Transfers
Group
Labor
Supply
Consumption Savings
Taxed
Increase
Small
Decrease
Large
Decrease
Beneficiary
Decrease
Large
Increase
Small
Increase
Net
0
Increase
Decrease
Transfers: Classical Analysis
• The transfer creates no net effect on labor markets.
Therefore, real wages, employment, and aggregate
output are unchanged.
Transfers: Classical Analysis
• The transfer creates no net effect on labor markets.
Therefore, real wages, employment, and aggregate
output are unchanged.
• A decline in aggregate savings raises interest rates
and lowers investment (government spending
“crowds out investment”)
Transfers: Classical Analysis
• The transfer creates no net effect on labor markets.
Therefore, real wages, employment, and aggregate
output are unchanged.
• A decline in aggregate savings raises interest rates
and lowers investment (government spending
“crowds out investment”)
• Higher interest rates lower money demand which
raises prices.
Transfers: Classical Analysis
• Using IS-LM-FE analysis.
The drop in aggregate
savings shifts IS to the
right
Transfers: Classical Analysis
• Using IS-LM-FE analysis.
The drop in aggregate
savings shifts IS to the
right
• Rising prices lowers real
money balances which
shifts LM to the left. The
economy ends up at point
A.
Transfers: Keynesian Analysis
• For the same reasons as
before, Keynesian analysis
would result in a
rightward supply shift.
Transfers: Keynesian Analysis
• For the same reasons as
before, Keynesian analysis
would result in a
rightward supply shift.
• However, without the
price increase, the
economy settles at the
intersection of IS and LM
– output (and
employment) temporarily
rise above the full
employment level
Government Purchases
• Again, assume the budget is always balanced – (G-T) = 0
• Government purchases involve the government using up resources to
provide government goods and services.
– Total Output = Private Output + Government Output
Government Purchases
• Again, assume the budget is always balanced – (G-T) = 0
• Government purchases involve the government using up resources to
provide government goods and services.
– Total Output = Private Output + Government Output
• The important question here is: Is Government output valued at more
or less than its cost?
– Y ( Total) – G = C + I
Government Purchases
• Again, assume the budget is always balanced – (G-T) = 0
• Government purchases involve the government using up resources to
provide government goods and services.
– Total Output = Private Output + Government Output
• The important question here is: Is Government output valued at more
or less than its cost?
– Y ( Total) – G = C + I
• If government output is valued at more (less) than cost, then the
economy experiences a positive (negative) income effect
Government Purchases
• Conventional wisdom suggests that most government
output is valued at or below cost. Why?
Government Purchases
• Conventional wisdom suggests that most government
output is valued at or below cost. Why?
– Public vs. Private goods
Government Purchases
• Conventional wisdom suggests that most government
output is valued at or below cost. Why?
– Public vs. Private goods
• With a negative income effect:
– Labor Supply increases (output and employment
increase)
– Savings Falls (interest rates rise)
– Consumption Falls
Government Purchases:
Classical Analysis
• Higher employment shifts
FE to the right while
lower savings shifts IS to
the right
Government Purchases:
Classical Analysis
• Higher employment shifts
FE to the right while
lower savings shifts IS to
the right
• Higher interest rates lower
money demand, which
raises prices and shifts LM
to the left.
Government Purchases:
Keynesian Analysis
• The Keynesian analysis
still results in the IS and
FE shift (although the FE
shift is inconsequential)
• With fixed prices, there is
no LM shift and the
economy settles at the
intersection of IS and LM
Summary
• Classical analysis generally presumes that
government spending provides very little
stimulus, but potentially large impacts on
inflation and interest rates
• Keynesian analysis a larger stimulus from
government spending with a smaller impact
on inflation and interest rates.
Tax Cuts
• As with government spending, there are two
types of tax cuts:
Tax Cuts
• As with government spending, there are two
types of tax cuts:
• Average rate cuts
• Marginal Rate cuts
Taxes: an example
• Suppose we have the following tax code:
– $5,000 deduction
– 10% on all taxable income less than $20,000
– 20% on all income greater that $20,000
Taxes: an example
• Suppose we have the following tax code:
– $5,000 deduction
– 10% on all taxable income less than $20,000
– 20% on all income greater that $20,000
• You currently earn $55,000 (your taxable income is $50,000).
Taxes: an example
• Suppose we have the following tax code:
– $5,000 deduction
– 10% on all taxable income less than $20,000
– 20% on all income greater that $20,000
• You currently earn $55,000 (your taxable income is $50,000).
– Your marginal tax rate is the percentage of each additional dollar
earned that is paid in taxes: in this case, your marginal rate is 20%
Taxes: an example
• Suppose we have the following tax code:
– $5,000 deduction
– 10% on all taxable income less than $20,000
– 20% on all income greater that $20,000
• You currently earn $55,000 (your taxable income is $50,000).
– Your marginal tax rate is the percentage of each additional dollar
earned that is paid in taxes: in this case, your marginal rate is 20%
– Your average rate is the percentage of your income paid in taxes.
In this case,
Tax Bill = .10(20,000) + .20(30,000) = $8,000
Average Rate = ($8,000/$55,000) = .145 = 14.5%
Taxes: An example
• Suppose that the standard deduction is
increased to $15,000.
– Your marginal rate is still 20%
– Your new average rate is:
Tax Bill = .10(20,000) + .2(20,000) = $6,000
Average Rate = ($6,000/$55,000) = .11 = 11%
Taxes: An Example
• Suppose that the government adopts a flat
tax with a $23,000 deduction and a 25% flat
rate:
Taxes: An Example
• Suppose that the government adopts a flat
tax with a $23,000 deduction and a 25% flat
rate:
– Your marginal rate increases (to 25%)
Taxes: An Example
• Suppose that the government adopts a flat
tax with a $23,000 deduction and a 25% flat
rate:
– Your marginal rate increases (to 25%)
– Your new average rate is:
Tax Bill = (.25)($32,000) = $8,000
Average Rate = (8,000/55,000) = 14.5%
Average Rates vs. Marginal Rates
• Recall that when we derived both labor
supply and savings, we talked about both
income and substitution effects:
– Marginal rates influence substitution effects
(people tend to do less of whatever is being
taxed)
– Average rates influence income effects
(wealthier people tend to work less, consume
more)
Example: A cut in marginal rates
• Suppose that the government cuts marginal rates across the
board, but lowers the deduction in such a way that
nobody’s tax bill changes (ie, average rates remain the
same)
Example: A cut in marginal rates
• Suppose that the government cuts marginal rates across the
board, but lowers the deduction in such a way that
nobody’s tax bill changes (ie, average rates remain the
same)
• Labor supply increases (an increase in take home pay
raises the cost of leisure) – employment and income
increase
Example: A cut in marginal rates
• Suppose that the government cuts marginal rates across the
board, but lowers the deduction in such a way that
nobody’s tax bill changes (ie, average rates remain the
same)
• Labor supply increases (an increase in take home pay
raises the cost of leisure) – employment and income
increase
• Higher employment increases MPK – investment increases
Marginal Rate Cut: Classical
Analysis
• The rise in
employment shifts the
FE curve to the right
Marginal Rate Cut: Classical
Analysis
• The rise in
employment shifts the
FE curve to the right
• Higher investment
shifts IS to the right
Marginal Rate Cut: Classical
Analysis
• The rise in
employment shifts the
FE curve to the right
• Higher investment
shifts IS to the right
• Prices fall – this raises
real balances and
shifts LM to the right
Marginal Rate Cut: Keynesian
Analysis
• Again, the analysis
leaves out the LM
shift and looks for the
intersection of IS and
LM
Example: average rate cuts
• Now, consider an tax cut where marginal rates are
unchanged, but everybody pays less total taxes – a good
example would be the $500/person rebate awarded in
2002.
Example: average rate cuts
• Now, consider an tax cut where marginal rates are
unchanged, but everybody pays less total taxes – a good
example would be the $500/person rebate awarded in 2002
• Since total taxes collected drops, two things happen:
– Assuming that government spending in constant, the deficit
(government borrowing) increases.
– Households see an increase in their disposable income. Or do they?
Average rate cuts
• Suppose that the government lowers taxes by $1,000 per
person. If government spending remains constant, how
does this impact your wealth? (Assume an interest rate of
5%)
Average rate cuts
• Suppose that the government lowers taxes by $1,000 per
person. If government spending remains constant, how
does this impact your wealth? (Assume an interest rate of
5%)
• If the government repays this extra borrowing by raising
your taxes next year, your taxes will have to increase by
$1,050 (to repay the debt plus the 5% interest)
Change in wealth = $1000 - $1,050/(1.05) = 0 !!
Average rate cuts
• Suppose that the government lowers taxes by $1,000 per
person. If government spending remains constant, how
does this impact your wealth? (Assume an interest rate of
5%)
• If the government repays this extra borrowing by raising
your taxes in two years, your taxes will have to increase by
$1,102.50 (to repay the debt plus the 5% interest
compounded over two years)
Change in wealth = $1000 - $1,102.50/(1.05)^2 = 0 !!
Average rate cuts
• Suppose that the government lowers taxes by $1,000 per
person. If government spending remains constant, how
does this impact your wealth? (Assume an interest rate of
5%)
• In fact, as long as the government pays back that loan in
your lifetime, your wealth will be unaffected. Why is this
important?
Average rate cuts
• Suppose that the government lowers taxes by $1,000 per
person. If government spending remains constant, how
does this impact your wealth? (Assume an interest rate of
5%)
• In fact, as long as the government pays back that loan in
your lifetime, your wealth will be unaffected. Why is this
important?
• Remember, forward looking individuals should be basing
labor and consumption decisions on wealth not income!!
Ricardian equivalence
• Ricardian equivalence states that if consumers are forward
looking, then household behavior is determined by
government spending, not the method of financing!
Ricardian equivalence
• Ricardian equivalence states that if consumers are forward
looking, then household behavior is determined by
government spending, not the method of financing!
• In the previous example, if Ricardian equivalence holds,
then the impact of the tax cut would be:
Ricardian equivalence
• Ricardian equivalence states that if consumers are forward
looking, then household behavior is determined by
government spending, not the method of financing!
• In the previous example, if Ricardian equivalence holds,
then the impact of the tax cut would be:
– Government borrowing rises by $1000 per person
– Private savings increases by $1000 per person
– Consumption, Investment, Employment, and Output and interest
rates are UNAFFECTED!
Suppose that households are
“fooled” by the tax cut
• If households actually feel wealthier by a
deficit financed cut in average tax rates,
how will they respond?
Suppose that households are
“fooled” by the tax cut
• If households actually feel wealthier by a
deficit financed cut in average tax rates,
how will they respond?
– Labor supply decreases, lowering employment
and output
– Consumption rises (savings does not increase
enough to compensate for higher government
borrowing) – interest rates rise
Average rate cuts
• The drop in
employment shifts the
FE curve to the left
Average rate cuts
• The drop in
employment shifts the
FE curve to the left
• The rise in
government borrowing
shifts the IS curve to
the right
Classical analysis
• Higher interest rates,
along with lower
output lower money
demand.
• Higher prices reduces
real balances – LM
shifts left
Keynesian Analysis
• Keynesians ignore the
FE shift – the
economy settles at the
intersection of IS and
LM
Summary
• Classical analysis suggests that only cuts in
marginal tax rates will provide stimulus to
the economy
• Keynesian analysis suggests that all tax cuts
can stimulate the economy – as long as
households feel wealthier (i.e., Ricardian
equivalence fails)
A final thought….
• The preceding review of fiscal policy was based
purely on positive analysis (what will happen).
However, what if we studied fiscal policy using a
normative analysis (what should happen). What
normative criterion should we use?
A final thought….
• The preceding review of fiscal policy was based
purely on positive analysis (what will happen).
However, what if we studied fiscal policy using a
normative analysis (what should happen). What
normative criterion should we use?
– Efficiency: Any policy which raises total output
increases efficiency
A final thought….
• The preceding review of fiscal policy was based
purely on positive analysis (what will happen).
However, what if we studied fiscal policy using a
normative analysis (what should happen). What
normative criterion should we use?
– Efficiency: Any policy which raises total output
increases efficiency
– Equity: An equitable policy improves “fairness”
Example: Jack and Jill
• Jack and Jill live on a desert island. The is a community
well on the island that Jack and Jill use equally. The well
costs $10,000 per year to maintain.
Example: Jack and Jill
• Jack and Jill live on a desert island. The is a community
well on the island that Jack and Jill use equally. The well
costs $10,000 per year to maintain.
Jack
Income = $20,000
Tax Paid = $2,000 (10%)
Example: Jack and Jill
• Jack and Jill live on a desert island. The is a community
well on the island that Jack and Jill use equally. The well
costs $10,000 per year to maintain.
Jack
Jill
Income = $20,000
Income = $100,000
Tax Paid = $2,000 (10%) Tax Pain = $8,000 (8%)
• As long as the well is valued collectively at more than
$10,000, this policy is efficient – regardless of how the tax
is split.
Example: Jack and Jill
• Jack and Jill live on a desert island. The is a community
well on the island that Jack and Jill use equally. The well
costs $10,000 per year to maintain.
Jack
Jill
Income = $20,000
Income = $100,000
Tax Paid = $2,000 (10%) Tax Pain = $8,000 (8%)
• As long as the well is valued collectively at more than
$10,000, this policy is efficient – regardless of how the tax
is split.
• Is this policy equitable?