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Chapter 11
Fiscal Policy
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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Fiscal policy
Short-term impact of government spending
The multiplier effect
Limitations of spending stimulus
Taxation
Incentives and taxes
Budget deficits and surpluses
11-2
Fiscal Policy
• Fiscal policy is defined as the economic
effect of government spending and taxes.
• Looks at the impact on the economy in both
short-term and long-term.
• In the short-term, fiscal policy consists of the
government’s budget decisions.
• In the long-term, fiscal policy creates the link
between government spending and taxation
decisions and the country’s economic growth.
11-3
Government and Economy
• Government spending and tax policy
have a major impact on the economy.
• Government spends directly on wages,
goods and services.
• It also shifts money from some people to
others in the form of Social Security,
Medicare, and other programs.
11-4
Government and Economy
• In the private sector, spending occurs
through market transactions.
– In this case, all transactions are voluntary.
• The level of government spending is set
by the political system, rather than the
economic system.
• Spending is funded through a combination
of taxation and borrowing.
– Unlike private sector, the government pays
back debts by raising taxes.
11-5
Short-Term Impact of Government
Spending
• Each year the federal budget is set in the
process that begins in February.
• Eventually the President and Congress come
to an agreement on the level of spending and
the tax rules.
• In the short term, an increase in government
spending lowers unemployment and
increases GDP, all other things being equal.
11-6
Short-Term Impact of Government
Spending
Wage
Supply curve for
labor
B
W1
A
W
Demand curve for
labor after increase in
government spending
Original demand
curve for labor
L
L1
Quantity of labor supplied and demanded
11-7
Short-Term Impact of Government
Spending
• The use of increases in government spending
and tax cuts to stimulate the economy and
combat the effects of recession is called the
Keynesian approach.
• This approach was developed by John
Maynard Keynes as a solution to the
economic problems caused by the Great
Depression.
• Increases in government spending and cuts
in taxes are called fiscal stimulus.
11-8
The Multiplier Effect
• The total economic impact of government
spending is greater than the initial amount
of spending.
– A government contract to build a new bridge
leads to hiring of construction workers.
However, the economic impact doesn’t end
there.
• These workers spend some of their paychecks in
the local economy.
– This spending leads to additional hiring by local
businesses, and further boosts the economy.
11-9
The Multiplier Effect
• Thus, the first round of spending creates
income that generates a second round of
spending and this induces a third round.
• The multiplier effect is the overall boost
in economic activity that flows from the
increase in government spending.
• We can state the multiplier as either a job
or spending multiplier.
11-10
The Multiplier Effect
– If the job multiplier is 2, this means that each new
government job creates one new private sector job.
– Suppose government spending rises by $100 billion.
A spending multiplier of 1.5 means that GDP goes up
by $150 billion – including $100 billion from the initial
spending and $50 billion due to the follow-up effects.
• The multiplier process also works in reverse,
so cuts in spending lead to job losses and lower
GDP.
11-11
Marginal Propensity to Consume
• The question is, what determines the size
of the multiplier?
– The main factor is the marginal propensity
to consume (MPC), or the portion of each
additional dollar of income that consumers
spend.
– MPC takes on values of 0 to 1.
– In general, low income households have a
MPC close to 1.
– In contrast, the richest households tend to
have a low MPC.
11-12
Marginal Propensity to Consume
– The multiplier will be higher if the government
spending goes to people with a high marginal
propensity to consume.
• A government project that hires unemployed
workers into long-term jobs will generally have a
big multiplier effect, because these workers are
likely to spend a lot of their wages.
• But a program that hands out money to rich
Americans is likely to have only a small impact on
GDP.
11-13
Overseas Leakage
• Another factor affecting the multiplier is the
amount of money spent on US-produced goods
versus foreign goods, or imports.
• In order to boost GDP, government spending
must increase production in the United States.
• But in a world where more products are made
overseas, it is possible that fiscal stimulus will
lead to increased imports, rather than to faster
growth at home.
– This transfer of domestic economic stimulus to foreign
markets is known as overseas leakage.
11-14
The Size of the Multiplier
• The multiplier depends on the value of
MPC and percentage of income
consumers spend on imported goods.
• Given these factors, most economists
believe the value of the job and spending
multipliers are between 1 and 2.
• Note: If the multiplier is below 1, it means
that higher government spending actually
causes the private sector to contract.
11-15
Limitations of Spending Stimulus
• There are downsides to stimulating the
economy through fiscal policy.
• These limit the extent to which
government can use spending to stimulate
the economy.
• The first limitation in attempting to use
government spending is inflation.
– In the short-term, an increase in government
spending raises wages and prices.
11-16
Limitations of Spending Stimulus
• If actual GDP is above
potential GDP, then
increases in government
spending will mostly turn
into inflation.
• But if unemployment is high
and actual GDP is below
potential GDP, then
increased government
spending is more likely to
turn into higher output.
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Limitations of Spending Stimulus
• A second limitation is due to lags in policy.
– It takes time to recognize that the economy is
in a recession and then pass the appropriate
legislation.
– If the spending comes when the economy is
already out of recession, then it actually adds
to inflation.
11-18
Taxation
• The main source of revenues for
government spending is taxation.
• The table on the next slide lists the various
taxes used to raise revenues.
• Compared to the size of the economy, tax
collections have not changed much over
the last 30 years.
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Taxation
Name of tax
Source of tax
Income tax
Individual income
Property tax
Payroll tax
The value of commercial and
residential real estate
Wage payments
Corporate income tax
Corporate profits
Sales tax
Retail sales
Excise tax
Items such as gasoline,
tobacco and alcohol
11-20
0.00
2007
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60
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63
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66
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69
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72
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75
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78
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81
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84
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87
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90
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93
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96
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99
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02
20
05
Ratio of federal, state, and local taxes and fees to GDP
Taxation versus GDP
0.35
0.30
0.25
0.20
0.15
0.10
0.05
11-21
Federal Income Taxes
11-22
Direct Impact Of Taxes
• Disposable income is defined as the
amount of income people have left after
paying taxes.
• Tax cuts increase disposable income,
while tax increases lower it.
• Thus, tax cuts are stimulative, and tax
increases are contractionary.
• If the economy goes into recession, the
government can cut taxes as a way of
stimulating the economy.
11-23
Direct Impact Of Taxes
Price of
cars
Supply curve for
cars
B
P1
A
P
Demand curve for
cars after income
tax cuts
Original demand
curve for cars
Q
Q1
Quantity of cars supplied and demanded
11-24
Incentives and Taxes
• There are incentive effects associated
with taxes.
• Higher taxes will discourage whatever
activity is being taxed.
• This link between taxes and incentives is
the essential insight of supply-side
economics.
• Supply-side economics focuses on the
marginal tax rate - that is, the tax you pay
on the last dollar of income you earn.
11-25
Incentive Effect of Taxes
Wage
Original tax
Reduced tax
Pre-tax
wage paid
by employer
Supply curve
for labor
Tax
After-tax W1
wage
received by
employee W
L
L1
Quantity of labor supplied and demanded
11-26
Top Marginal Tax Rate
11-27
Borrowing
• If there is a gap between spending and tax
revenues, the government has to borrow.
• The excess of the federal government’s
spending over its revenues is the budget
deficit. If revenues exceed spending, we have a
budget surplus.
• To pay for the budget deficit, the government
borrows money from investors.
• The total of all the government’s borrowing is
called the public debt.
11-28
Federal Budget Surplus or Deficit
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Effect of Borrowing
• In the short run, an increasing federal
budget deficit stimulates the economy.
• Government borrowing has a negative
effect, in that a rising budget deficit pushes
up interest rates and crowds out private
investment.
• This is known as crowding out.
• Crowding out has a negative impact on
long-term growth.
11-30
Crowding Out
Interest
rate
Supply curve for
loans
B
r1
A
r
New demand curve for
loans, including
government borrowing
Demand curve
for loans
L
L1
Quantity of money borrowed and lent
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Summary of Impacts of Fiscal Policy
Fiscal Policy Action
How can it help?
How can it hurt?
Increase government
spending
Create jobs and boost
GDP
Can boost inflation
and widen budget
deficit.
Lower taxes
Create jobs and boost
GDP, incentives for
work and investment
Can boost inflation
and widen budget
deficit.
Accept wider budget
deficit
Create jobs and boost
GDP
Can lead to higher
interest rates and
lower private
investment; lowers
long-term GDP
growth.
11-32