Download AD 2

An Overview of Government
Spending and Taxes
Federal government expenditures:
• Purchases.
• Interest on the national debt.
• Grants to state and local
governments.
• Transfer payments.
The Federal Government’s Share of Total
Government Expenditures, 1929–2010
Federal Purchases and Federal Expenditures
as a Percentage of GDP, 1950–2010
Federal Government Expenditures, 2010
Federal Government Revenue, 2010
Price
Level
market selfadjustment
may be a lengthy
process.
LRAS
SRAS1
SRAS2
E2
P2
P1
e1
P3
E3
directs the
Economy to
full-employment
AD1 AD2
Y 1 YF
Goods & Services
(real GDP)
• Equilibrium below full employment. Two options
1. Wait for SRAS1 to shift out to SRAS2
2. Shift AD1 out to AD2
Price
Level
SRAS2
LRAS
SRAS1
P3
E3
P1
P2
e1
E2
restrains demand and
helps control inflation.
AD2 AD1
YF Y 1
Goods & Services
(real GDP)
• Equilibrium above full employment at Y1.
1. Will lead to the long-run equilibrium E3 at a
higher price level as SRAS shifts to SRAS2. or
2. Reduce demand to AD2 and lead to equilibrium E2.
A Summary of How Fiscal Policy Affects
Aggregate Demand
Countercyclical Fiscal Policy
Actions by Congress
and the President
Result
Problem
Type of Policy
Recession
Expansionary
Increase government
spending or cut taxes
Real GDP and the
price level rise.
Rising
inflation
Contractionary
Decrease government
spending or raise taxes
Real GDP and the
price level fall.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
12 of 75
The initial increase in government purchases is
autonomous
it is a result of a decision by the government and
is not directly caused by changes in the level of
real GDP.
The increases in consumption spending that result from
the initial autonomous increase in government
purchases are induced
because they are caused by the initial increase in
autonomous spending.
The Multiplier Effect and Aggregate Demand
Multiplier effect The series of induced increases in
consumption spending that results from an initial
increase in autonomous expenditures.
The Multiplier Effect of an Increase in Government Purchases
The new spending and increased real GDP in
each period is shown in green, and the level of
spending from the previous period is shown in
orange.
The sum of the orange and green areas
represents the cumulative increase in
spending and real GDP.
In total, equilibrium real GDP will increase
by $200 billion as a result of an initial
increase of $100 billion in government
purchases.
The ratio of the change in equilibrium real GDP to the
initial change in government purchases:
Government purchases multiplier 
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
Change in equilibriu m real GDP
Change in government purchases
16 of 75
Tax cuts also have a multiplier effect.
Change in equilibriu m real GDP
Tax multiplier 
Change in taxes
The tax multiplier is negative because changes in taxes
and changes in real GDP move in opposite directions:
An increase in taxes reduces disposable income,
consumption, and real GDP,
and a decrease in taxes raises these.
We would expect the tax multiplier to be smaller in
absolute value than the government purchases
multiplier.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
17 of 75
The Multiplier Effect and Aggregate Supply
The economy is initially at
point A.
An increase in government
purchases causes the
aggregate demand curve to
shift to the right, from AD1
to the dashed AD curve.
The multiplier effect results
in the aggregate demand
curve shifting further to the
right, to AD2 (point B).
Because of the upwardsloping supply curve,
the shift in aggregate demand results in a higher price level.
In the new equilibrium at point C, both real GDP and the price level have increased.
The increase in real GDP is less than indicated by the multiplier effect with a constant price
level.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
18 of 75
The Effect of Changes in Tax Rates
A change in tax rates has a more complicated effect
on equilibrium real GDP than does a tax cut of a fixed
amount.
The higher the tax rate, the smaller the multiplier
effect.
A cut in tax rates affects equilibrium real GDP through
two channels:
1. A cut in tax rates increases the disposable income
of households, which leads them to increase their
consumption spending (and saving).
2. A cut in tax rates increases the size of the multiplier
effect.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
19 of 75
The Multipliers Work in Both Directions
Increases in government purchases and cuts in taxes have a
positive multiplier effect on equilibrium real GDP.
Decreases in government purchases and increases in taxes
also have a multiplier effect on equilibrium real GDP, but in
this case, the effect is negative.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
20 of 75
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
1. Equilibrium at E0
2. AD decreases to AD1 and output falls to Y1
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD2
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
3. While policy is being enacted, private investment
has begun to recover.
4. AD has begun shifting back to AD0 on its own, the
effects of fiscal policy over-shift AD to AD2.
Price
Level
LRAS
SRAS2
SRAS1
P3
E3
P2
e2
P0
P1
E0
e1
AD2
AD0
AD1
Y1 Y0 Y2
Goods & Services
(real GDP)
• The price level in the economy rises (from P1 to P2) as
the economy is now overheating.
• Unless the expansionary fiscal policy is reversed, wages
and other resource prices will eventually increase,
shifting SRAS back to SRAS2 (driving the price level up
to P3).
Price
Level
LRAS
SRAS1
P2
P0
e2
E0
AD2
AD0
Y0 Y2
Goods & Services
(real GDP)
1. Demand shifts AD out to AD2, and prices upward to P2.
2. Restrictive Fiscal Policy is considered
Price
Level
LRAS
SRAS1
P2
e2
P0
P1
E0
e1
AD2
AD0
AD1
Y1 Y0 Y2
Goods & Services
(real GDP)
2. The price level falls (from P2 to P1) as the
economy is thrown into a recession.
3. With the timing lag, fiscal policy does not work
instantaneously.
Price
Level
LRAS
SRAS1
Suppose that shifts in AD
e2 are difficult to forecast.
P2
P0
E0
AD2
AD0
AD1
Y0 Y2
Goods & Services
(real GDP)
4. Investment returns to its normal rate
(shifting AD2 back to AD0).
5. The effects of fiscal policy over-shift AD to AD1.
Decline in
private investment
Increase in
budget deficit
Higher real
interest rates
Inflow of financial
capital from abroad
Appreciation
of the dollar
Decline in
net exports
Did the Stimulus Package of 2009 Work?
1. Congress enacted a tax cut totaling $95 billion that
took the form of rebates of taxes already paid that
were sent to taxpayers between April and July 2008.
2. One-time tax rebates increase consumers’ current
income but not their permanent income, which reflects
their expected future income.
3. A tax rebate is likely to increase consumption spending
less than would a permanent tax cut.
American Recovery and Reinvestment Act of 2009
Panel (a) shows how the increases in spending were distributed,
and panel (b) shows how the tax cuts were distributed.
CBO Estimates of the Effects of the Stimulus Package
Year
Change in Real
GDP
Change in the
Unemployment Rate
Change in
Employment
(millions of people)
2009
0.9% to 1.9%
−0.3% to −0.5%
0.5 to 0.9
2010
1.5% to 4.2%
−0.7% to −1.8%
1.3 to 3.3
2011
0.8% to 2.3%
−0.5% to −1.4%
0.9 to 2.7
2012
0.3% to 0.8%
−0.2% to −0.6%
0.4 to 1.1
Why Was the Recession of 2007–2009 So Severe?
The recession of 2007-2009 was accompanied by a significant financial
crisis, which the U.S. economy had not experienced since the Great
Depression of the 1930s.
Why Was the Recession of 2007–2009 So Severe?
The table shows the average change in key economic variables during
the period following a financial crisis for a number of countries, including
the United States during the Great Depression and European and Asian
countries in the post–World War II era.
Economic
Variable
Average Change
Average
Duration
of Change
Number of
Countries
Unemployment
rate
+7 %
4.8 years
14
Real GDP per
capita
−9.3%
1.9 years
14
Real stock prices
−55.9%
3.4 years
22
Real house prices
−35.5%
6 years
21
Real government
debt
+86%
3 years
13
Why Was the Recession of 2007–2009 So Severe?
Average for postwar
recessions
Duration
Decline in
Real GDP
Peak Unemployment
Rate
10.4 months
−1.7%
7.6%
−4.1%
10.1%
Recession of 2007–2009 18 months
The recession lasted nearly twice as long as the average of earlier
postwar recessions, GDP declined by more than twice the average, and
the peak unemployment rate was about one-third higher than the
average.
Because most people did not see the financial crisis coming, they also
failed to anticipate the severity of the 2007–2009 recession.
Expenditures > Revenue
Expenditures < Revenues
Discretionary changes in taxes
and/or spending affect the
Budget
Most of the increase in the federal budget deficit during a typical
recession takes place without Congress and the president taking
any action, but is instead due to the effects of the automatic
stabilizers.
Deficits occur automatically during recessions for two reasons:
1. During a recession, wages and profits fall, causing government
tax revenues to fall.
2. The government automatically increases its spending on transfer
payments when the economy moves into recession.
Many economists believe that it is a good idea for the
federal government to have a balanced budget when
the economy is at potential GDP.
Attempting to balance it every year might mean taking
actions that would destabilize the economy.
Some even argue that the federal government should
normally run a deficit, even at potential GDP.
The large deficits incurred during World Wars I and II,
the Great Depression, and the 1980s and early 1990s
increased the ratio of debt to GDP.
The large deficits of 2009 to 2011 caused the ratio to
spike up to its highest level since 1947.
The federal government can raise the funds it
needs through taxes or spending cuts.
If crowding out occurs, there will be a lower
capital stock in the long run and a reduced
productive capacity.
Some of the debt was incurred to finance
improvements in infrastructure, or to finance
research and development.
“Because fiscal policy actions primarily affect aggregate supply
rather than aggregate demand, they are sometimes referred to as
supply-side economics.”
The Long-Run Effects of Tax Policy
Tax wedge The
difference between the pretax and
posttax return to an economic activity.
When workers, savers, investors, or entrepreneurs
change their behavior as a result of a tax change,
economists say that there has been a behavioral
response to the tax change.
We next look briefly at the effects on aggregate supply
of cutting some common taxes.
1. Individual income tax. Sole proprietorships’ profits
and households’ returns from saving are taxed at the
individual income tax rates.
So, cutting these rates not only reduces the tax
wedge faced by workers, thereby increasing the
quantity of labor supplied, but also raises the
return to entrepreneurship, encouraging the
opening of new businesses, and increases the
return to saving.
People are not working because taxes are too
high.
• Corporate income tax. The federal government
taxes the profits earned by corporations under the
corporate income tax.
Cutting the marginal corporate income tax rate would
encourage investment spending by increasing the return
corporations receive from new investment goods,
potentially increasing the pace of technological change
if innovations are embodied in these goods.
or…
Increase profits of business owners
• Taxes on dividends and capital gains. Corporations
distribute some of their profits in the form of
payments known as dividends to shareholders, who may
benefit from higher corporate profits by receiving
capital gains, which are increases in the prices of assets.
Lowering the tax rates on dividends and capital gains
increases the supply of loanable funds from households
to firms, increasing saving and investment and lowering
the equilibrium real interest rate.
Tax Simplification
If the tax code were greatly simplified, the economic
resources currently used by the tax preparation
industry would be available to produce other goods and
services. Put HB Block out of business
In addition to wasting resources, the complexity of the
tax code may also distort the decisions made by
households and firms.
A simplified tax code would increase economic
efficiency by reducing the number of decisions
households and firms make solely to reduce their tax
payments.
The Supply-Side Effects of a Tax Change
Figure 16.16
The economy’s
initial equilibrium
is at point A.
With no tax change,
the long-run
aggregate supply
curve shifts to the
right, from LRAS1
to LRAS2.
Equilibrium moves
to point B, with the
price level falling
from P1 to P2
and real GDP increasing from Y1 to Y2.
With tax reductions and simplifications,
the long-run aggregate supply curve shifts further to the right, to LRAS3,
and equilibrium moves to point C, with the price level falling to P3
and real GDP increasing to Y3.
How Large Are Supply-Side Effects?
Most (?) economists would agree that there are supply-side effects
to reducing taxes:
Decreasing marginal income tax rates will increase the quantity of
labor supplied, cutting the corporate income tax will increase
investment spending, and so on.
The magnitude of the effects is the subject of considerable debate,
however.
Economists who are skeptical of their magnitude believe that tax
cuts have their greatest effect on aggregate demand rather
than on aggregate supply.
Price
Level
LRAS1 LRAS2
SRAS1
SRAS2
P0
E1
E2
AD1
YF1
YF2
With time, lower tax rates
promote more rapid growth
(shifting LRAS and SRAS
out to LRAS2 and SRAS2).
AD2
Goods & Services
(real GDP)
1. Lower marginal tax rates shifts AD1 out to AD2,
and SRAS & LRAS shift to the right.
2. If the tax cuts are financed by budget deficits, AD
may expand by more than supply, bringing an
increase in the price level.
Share of personal income taxes
paid by top ½ % of earners
30 %
28 %
26 %
24 %
22 %
20 %
1964-65
Top rate cut from
91% to 70%
2001-2004
Top rate cut from
39.6% to 35%
1990-93
Top rate raised from
30% to 39.6%
1986
Top rate cut from
50% to 30%
1997
Capital gains
tax rate cut
18 %
1981
Top rate cut from
70% to 50%
16 %
14 %
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
• Their share of taxes paid has increased as the top
tax rates have declined.
• This indicates that the supply side effects are
strong for these taxpayers.
O
b
a
m
a