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Survey of ECON
© SHAWN THEW/EPA/CORBIS
Robert L. Sexton
Chapter 14 Fiscal Policy
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Chapter 14 Sections
– Fiscal Policy
– Government Spending and Taxation
– Fiscal Policy and the AD/AS Model
– The Multiplier Effect
– Supply-Side Effects of Tax Cuts
– Automatic Stabilizers
– The National Debt
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Fiscal Policy
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Section 1
SECTION 1 QUESTIONS
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Fiscal Policy
FISCAL POLICY
use of government purchases, taxes, and
transfer payments to alter equilibrium output
and prices
• The government can use fiscal policy to
stimulate the economy out of a recession
or to try to bring inflation under control.
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Fiscal Stimulus Affects
the Budget
BUDGET DEFICIT
occurs when government spending exceeds
tax revenues for a given fiscal year
BUDGET SURPLUS
occurs when tax revenues are greater than
government expenditures for a given fiscal
year
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Fiscal Stimulus Affects
the Budget
• A balanced budget, where government
expenditures equal tax revenues, seldom
occurs unless efforts are made to
deliberately balance the budget as a
matter of public policy.
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Fiscal Stimulus Affects
the Budget
• When the government wishes to stimulate
the economy by increasing AD, it will:
– Increase government purchases of goods and
services
– Increase transfer payments
– Lower taxes
– Use some combination of these approaches
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Fiscal Stimulus Affects
the Budget
• Any of those options will increase the
budget deficit (reduce budget surplus).
• Thus, expansionary fiscal policy
is associated with increased government
budget deficits.
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Fiscal Stimulus Affects
the Budget
• If the government wishes to dampen an
economic boom by reducing AD, it will
– Reduce its purchases of goods and services
– Increase taxes
– Reduce transfer payments
– Use some combination of these approaches
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Fiscal Stimulus Affects
the Budget
• Thus, contractionary fiscal policy will
tend to create or expand a budget surplus
or reduce a budget deficit, if one exists.
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The Government and Total
Spending
• Aggregate demand is equal to consumer
spending, investment spending,
government purchases, and net exports.
(X – M): AD = C + I + G + (X – M)
• The government directly controls
government purchases, but it can also
indirectly affect AD through taxes and
transfer programs.
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The Government and Total
Spending
• An increase in taxes and/or a reduction in
transfer payments can reduce disposable
income and decrease consumer spending.
• A decrease in taxes and/or an increase in
transfer payment can increase disposable
income and lead to an increase in
consumer spending.
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The Government and Total
Spending
• The government can influence investment
spending through business taxes.
• A tax cut for firms may increase
investment spending and shift the
aggregate demand curve to the right.
• Thus, the government can change
aggregate demand in a number of ways.
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Section 1
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Government Spending
and Taxation
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Section 2
SECTION 2 QUESTIONS
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Government Spending
and Taxation
• Government plays a large role in the
economy; and its role increased
markedly between 1930 and 1975.
• Federal spending has changed little since
1960, but the composition of government
spending has changed considerably.
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SOURCES: Economic Report of the President, 2010. Statistical Tables. Tables B-79 and B-86. Washington, D.C. February, 2010.
Available at http://www.gpoaccess.gov/eop/tables10.html (accessed March 25, 2010); Christopher Chantril, “Time Series Chart of U.S.
Government Spending,” usgovernmentspending.com. Available at http://www.usgovernmentspending.com/downchart_gs.php?year=
1930_2010&view=1&expand=&units=p&fy=fy11&chart=F0-fed_F0-statelocal&bar=0&stack=1&size=m&title=&state=
US&color=c&local=c (accessed April 20, 2010).
Exhibit 14.1: Growth of Government Expenditures as a
Percentage of GDP in the United States, 1930–2010
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SOURCES: Economic Report of the President, 2010. Statistical Tables. Table B-80. Washington, D.C. February, 2010. Available at
http://www.gpoaccess.gov/eop/tables10.html (accessed March 25, 2010); U.S. Census Bureau, State & Local Government Finance 2007, U.S.
Summary. Washington, D.C. December 11, 2009. Available at http://www.census.gov/govs/estimate/ (accessed April 6, 2010).
Exhibit 14.2: Government Expenditures
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Generating Government
Revenue
• In most years, a large majority of government
activity is financed by taxation.
• What kinds of taxes are levied on the
American population?
• At the federal level, most taxes or levies are
on income.
• 50 percent of tax revenues come in the form of
income taxes on individuals and corporations,
called personal income taxes and corporate
income taxes, respectively.
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Generating Government
Revenue
• Most of the remaining revenues come from payroll
taxes, which are levied on work-related income, that
is, payrolls.
• These taxes are used to pay for Social Security and
compulsory insurance plans such as Medicare.
• Payroll taxes are split between employees and
employers.
• Other taxes, on such items as gasoline, liquor, and
tobacco products, provide for a small proportion of
government revenues, as do customs duties, estate
and gift taxes, and some minor miscellaneous taxes
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and user charges.
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SOURCE: Economic Report of the President, 2010. Statistical Tables. Table B-80 and Table B-86. Washington, D.C. February, 2010. Available at
http://www.gpoaccess.gov/eop/tables10.html (accessed March 25, 2010).
Exhibit 14.3: Tax Revenues
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A Progressive Tax
• Progressive taxes are designed so that
those with higher incomes pay a greater
proportion of their income in taxes.
• A progressive tax is one tool that the
government can use to redistribute income.
• However, certain types of income are
excluded from income for taxation purposes,
such as interest on municipal bonds and
income in kind—food stamps or Medicare.
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A Regressive Tax
• Regressive tax – As a person’s income
rises, the amount his or her tax as a
proportion of income falls.
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Exhibit 14.4: Payroll Tax
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An Excise Tax
• An excise tax is a sales tax on individual
products such as alcohol, tobacco, and
gasoline.
• Some consider it to be the most unfair
type of tax because it is generally the most
regressive.
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Financing State and Local
Government Activities
• Historically, the primary source of state
and local revenue has been property
taxes. In recent decades, state and local
governments have relied increasingly on
sales and income taxes for revenues.
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Should We Have a Flat Tax?
• A flat tax, also called a proportional tax,
is designed so that everybody would be
charged the same percentage of their
income.
• With a flat tax, a household could simply
report its income, multiply it by the tax
rate, and send in the money. Because no
deductions are involved, the form could
be a simple page! But most flat tax
proposals call for exempting income to a
certain level—say, the poverty line.
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Should We Have a Flat Tax?
• Actually, if the flat tax system allows
individual taxpayers to take a standard
allowance, like most flat tax proposals,
then the tax is actually progressive.
• That is, lower- and middle-income families
will pay, on average, a smaller average tax
rate, even though everyone has the same
tax rate over the stipulated allowance.
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Should We Have a Flat Tax?
• The advantages of the flat tax are that all of the
traditional exemptions, such as entertainment
deductions, mortgage interest deductions,
business travel expenses, and charitable
contribution deductions, would be out the door,
along with the possibilities of abuses and
misrepresentations that go with tax deductions.
• Taxpayers could fill out tax returns in the way
they did in the old days, in a space about the size
of a postcard.
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Should We Have a Flat Tax?
• Advocates of flat tax argue that the
government could collect the same
amount of tax revenues, but the tax would
be much more efficient, as many
productive resources would be released
from looking for tax loopholes to doing
something productive from society’s
standpoint.
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Should We Have a Flat Tax?
• Of course, some versions of the flat tax
will hurt certain groups.
• Realtors and homeowners, who like the
mortgage interest deductions, and tax
accountants, who make billions every year
preparing tax returns, will not be
supportive of a flat tax with no deductions.
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Taxes: Efficiency and
Equity
• Taxes for the most part are not efficient
(except for internalizing externalities
and providing public goods) because
they change incentives and distort the
values that buyers and sellers place on
goods and services.
• Taxes can be inefficient because they
may lead to less work, less saving, less
investment, and lower output.
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Taxes: Efficiency and
Equity
• Income redistribution through taxation may
also lead to greater productivity for lowincome workers through improvements in
health and education.
• Even though what is fair to one person
may not be fair to another, we should have
a fair tax system based on either ability to
pay or benefits received.
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Ability to Pay Principle and
Vertical Equity
ABILITY TO PAY PRINCIPLE
belief that those with the greatest ability to pay taxes
should pay more than those with less ability to pay
VERTICAL EQUITY
different treatment based on level of income and the
ability to pay principle
• The federal income tax is a good example of the ability
to pay principle as under it high-income individuals pay
a higher percentage of their income in taxes than lowincome individuals.
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Benefits Received Principle
• The benefits received principle means that
the individuals receiving the benefits are those
who pay for them.
• Take for example the gasoline tax: the more
miles one drives on the highway, the more
gasoline used and the more taxes collected.
• Although this principle may work for some
private goods, it does not work well for public
goods such as national defense and the
judicial system. Because we collectively
consume national defense, it is not possible to
find out who benefits and by exactly how much.
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Administration Burden of
Taxation
• The administration burden of the income tax
also leads to another deadweight loss.
• A simplified tax system would reduce the
deadweight loss.
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Social Policy of Taxes
• Taxes and subsidies can be efficiency
enhancing when they lead to externalities.
• For example, the government may view it as
good social policy to subsidize cleaner, more
efficient hybrid vehicles. Or they may want to
put a high tax on cigarettes in an attempt to
reduce teen smoking. In other words, taxes on
alcohol and cigarettes may be used to
discourage these activities—sometimes we call
these “sin taxes.”
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Section 2
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Fiscal Policy and the
AD/AS Model
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Section 3
SECTION 3 QUESTIONS
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Fiscal Policy and the AD/AS
Model
• The primary tools of fiscal policy can be
presented in the context of the aggregate
supply and demand model, using
government purchases, taxes, and
transfer payments.
• Government can use fiscal policy as
either an expansionary or contractionary
tool to help close a recessionary or an
inflationary gap.
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Exhibit 14.5: Expansionary Fiscal Policy to
Close a Recessionary Gap
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Fiscal Policy and the AD/AS
Model
• When the government purchases more,
taxes less, and/or increases transfer
payments, the size of the government’s
budget deficit will grow.
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Fiscal Policy and the AD/AS
Model
• Although budget deficits are often thought
to be bad, a case can be made for using
budget deficits to stimulate the economy
when it is operating at less than full
capacity.
• Such expansionary fiscal policy has the
potential to move an economy out of a
recession and closer to fuller employment.
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Expansionary Fiscal Policy to
Close a Recessionary Gap
• If the government decides to purchase
more, cut taxes, and/or increase transfer
payments, ceteris paribus, total
purchases will rise, shifting AD curve to
the right.
• The effect of this increase in AD
depends on the position of the
macroeconomic equilibrium prior to the
government stimulus.
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Expansionary Fiscal Policy to
Close a Recessionary Gap
• In an initial recession scenario, with real
output below potential RGDP, a rise in
government purchases, a tax cut, and/or
increase in transfer payments increases
the size of the budget deficit and leads to
an increase in AD.
• This would result in an increase in the
price level and an increase in RGDP.
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Expansionary Fiscal Policy to
Close a Recessionary Gap
• Remember that some of this increase in
AD is caused by the multiplier process,
so the magnitude of the change in AD
will be much larger than the magnitude
of the stimulus package of tax cuts,
increases in transfer payments, and/or
government purchases.
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Expansionary Fiscal Policy to
Close a Recessionary Gap
• If the policy change is of the right
magnitude and timed appropriately, the
expansionary fiscal policy could stimulate
the economy, pulling it out of recession,
and resulting in full employment, thus
closing the recessionary gap.
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Contractionary Fiscal Policy to
Close an Inflationary Gap
• Suppose that the government decides to
reduce its purchases, increase taxes, or
reduce transfer payments; this change
may directly affect AD.
• A tax increase on consumers or a
decrease in transfer payments will
reduce households’ disposable incomes.
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Contractionary Fiscal Policy to
Close an Inflationary Gap
• In turn, it will reduce purchases of
consumption goods and services, and
higher business taxes will reduce
investment purchases.
• The reductions in consumption,
investment, and/or government purchases
will shift the aggregate demand curve
leftward.
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Contractionary Fiscal Policy to
Close an Inflationary Gap
• This shift thus lowers the price level and
brings RGDP back to the full-employment
level, resulting in a new short- and longrun equilibrium, closing the inflationary
gap.
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Exhibit 14.6: Contractionary Fiscal Policy
to Close an Inflationary Gap
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Section 3
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The Multiplier Effect
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Section 4
SECTION 4 QUESTIONS
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The Multiplier Effect
• Any one of the major spending
components of AD (C, I, G, or X – M) can
initiate changes in aggregate demand,
and thus a new short-run equilibrium.
• Policymakers that are unhappy with the
present short-run equilibrium GDP, may
consider unemployment too high
because of a current aggregate demand
shortfall.
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The Multiplier Effect
• An increase in government purchases
would lead to an increase in aggregate
demand.
• That is, they can deliberately
manipulate the level of government
purchases to obtain a new short-run
equilibrium value.
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What Is the Multiplier
Effect?
• Multiplier effect
– Usually, when an increase in purchases of
goods or services occurs, the ultimate increase
in total purchases will tend to be greater than
the initial increase.
• The multiplier effect illustrated:
– The government spends $10 billion to buy
aircraft carriers.
– This purchase adds to the total demand for
goods and services directly
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What Is the Multiplier
Effect?
– The government purchase provides $10
billion in added income to the companies
that construct the aircraft carriers.
– Companies will hire more workers and buy
more capital equipment and inputs to
produce the new output.
– Input owners therefore receive more income.
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What Is the Multiplier
Effect?
• What will input owners do with this
additional income?
• Behaviors will vary somewhat, but
collectively a substantial part will be:
– Spent on additional consumption purchases
– Paid in additional taxes incurred because of
the income
– Saved
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What Is the Multiplier Effect?
• The fraction of additional disposable (aftertax) income that a household consumes
rather than saves is the marginal
propensity to consume (MPC).
• That is, MPC is equal to the change in
consumption spending (∆C) divided by the
change in disposable income (∆DY).
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The Multiplier Effect:
Example
• Having won a lottery of $1000, you
might decide to spend $750 today
and save $250. In this example, your
marginal propensity to consume is
0.75 (or 75 percent).
• The term marginal propensity to
consume has two parts:
– Marginal refers to the fact that you
received an extra amount of disposable
income—an addition to your income, not
your total income
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Marginal Propensity to Save
– Propensity to consume refers to how much
you tend to spend on consumer goods and
services out of your additional income.
• The flip side of the marginal propensity
to consume is the marginal
propensity to save (MPS).
– The proportion of an addition to your
income that you would save, or not spend
on goods and services today.
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Marginal Propensity to Save
• MPS is equal to the change in savings
(∆S) divided by the change in
disposable income (∆DY).
• In the lottery example, your marginal
propensity to save is 0.25, or 25
percent.
• The marginal propensity to consume
plus the marginal propensity to save
must add up to 1, or 100 percent.
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The Multiplier Effect
at Work
• The multiplier effect is worked out
for an assumed MPC of two-thirds.
• The initial $10 billion increase in
government purchases causes both
a $10 billion increase in aggregate
demand and an income increase of $10
billion to suppliers of the inputs used to
produce aircraft carriers.
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The Multiplier Effect at Work
• The owners of those inputs, in turn, will
spend an additional $6.67 billion
(two-thirds of $10 billion) on additional
consumption purchases.
• A chain reaction has been started.
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The Multiplier Effect at Work
• The added $6.67 billion in consumption
purchases by those deriving income from
the initial investment brings a $6.67 billion
increase in aggregate demand and in new
income to suppliers of the inputs that
produced the goods and services.
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The Multiplier Effect at Work
• They in turn will spend two-thirds of their
additional $6.67 billion in income, or
$4.44 billion on consumption purchases.
• This $4.44 billion becomes aggregate
demand and income to yet another
group, who then proceed to spend
two-thirds of that amount, or $2.96
billion, on consumption purchases.
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The Multiplier Effect at Work
• The chain reaction continues, with each
new round of purchases providing
income to a new group of persons who
in turn increase their purchases.
• At each round, the added income
generated and the resulting consumer
purchases get smaller because some
of the increase in income goes to
savings and tax payments.
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Exhibit 14.7: The Multiplier Process
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The Multiplier Effect at Work
• What is the total impact of the initial
increase in purchases, after all the
rounds of additional purchases and
income have occurred?
• The multiplier is equal to 1 divided by 1
minus the marginal propensity to
consume.
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Changes in the MPC Affect
the Multiplier Process
• Note that the larger MPC, the larger the
multiplier effect, because relatively
more additional consumption
purchases out of any given income
increase generates relatively larger
secondary and tertiary income effects
in successive rounds of the process.
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The Multiplier and the
Aggregate Demand Curve
• Buying additional aircraft affects AD by
increasing the incomes of input owners,
including profits that go to the owners of
the firms involved―this is the initial
effect.
• The secondary effect―the greater
income that results―will lead to
increased consumer purchases.
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The Multiplier and the
Aggregate Demand Curve
• In addition, the higher profits for the firms
involved in carrier construction may lead
them to increase their investment
purchases.
• So the initial effect of the government’s
purchases will tend to have a multiplied
effect on the economy.
76
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The Multiplier and the
Aggregate Demand Curve
• The initial impact of a $10 billion additional
purchase by the government directly shifts AD
right by $10 billion.
• The multiplier effect then causes AD to shift
$20 billion further to the right.
• The total effect on AD of a $10 billion increase
in government purchases is therefore $30
billion, if the marginal propensity to consume
equals 2/3.
77
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Exhibit 14.8: The Multiplier Effect
78
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Tax Cuts and the Multiplier
• If the government finds that it needs to
use fiscal stimulus to move the economy
to the natural rate, increased government
spending is only one alternative.
• The government can also stimulate
business and consumer spending
through tax cuts.
79
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Tax Cuts and the Multiplier
• How much of an AD shift do we get from
a change in taxes?
• It depends on the marginal propensity to
consume.
• The tax multiplier is smaller than the
government spending multiplier because
government spending has a direct impact
on AD, whereas a tax cut has only an
indirect impact on aggregate demand.
80
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Tax Cuts and the Multiplier
• This is because consumers will save
some of their income from the tax cut.
• To compare the multiplier effect of a tax
cut with an increase in government
purchases, suppose there was a $10
billion tax cut and that the MPC is 2/3.
81
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Tax Cuts and the Multiplier
• The initial increase in consumption
spending from the tax cut would be
2/3 × $10 billion (MPC × tax cut) =
$6.67 billion.
• Since people would save one-third of
their tax cut income, the effect on AD of
the change in taxes would be smaller
than that of a change of equal size in
government purchases.
82
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Tax Cuts and the Multiplier
• The cumulative change in spending (the
increase in AD) due to the $10 billion tax
cut is found by plugging the initial effect
of the changed consumption spending
into the formula, to arrive at $20 billion.
• So the initial tax cut of $10 billion leads to
a stimulus of $20 billion in consumer
spending.
83
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Taxes and Investment
Spending
• Taxes can also stimulate investment
spending.
• If a cut in corporate-profit taxes leads to
expectations of greater after-tax profits, it
could fuel additional investment
spending.
• Tax cuts designed for consumers and
investors can stimulate both the C and I
components of aggregate demand.
84
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A Reduction in Government
Purchases and Tax Increases
• A reduction in government purchases and
tax increases are magnified by the
multiplier effect, too.
• If the government made cutbacks in the
space program
– It would decrease government purchases
directly.
– Aerospace workers would be laid off.
– Unemployed workers would cut back on their
consumption spending.
85
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A Reduction in Government
Purchases and Tax Increases
• This initial cutback would have a
multiplying effect through the economy,
leading to an even greater reduction in
aggregate demand.
86
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A Reduction in Government
Purchases and Tax Increases
• Similarly, tax hikes would leave
consumers with less disposable income,
thus:
– They would cut back on their consumption.
– This in turn would lower aggregate demand
and set off the multiplier process.
– This would then lead to an even larger
cumulative effect on aggregate demand.
87
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Time Lags, Saving, and Imports
Reduce the Size of the Multiplier
• Multiplier process is not instantaneous.
– Time lags mean that the ultimate increase in
purchases resulting from an initial increase in
purchases may not be achieved for a year or
more.
– The extent of the multiplier effect visible within a
short time period will be less than the total effect
indicated by the multiplier formula.
88
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Time Lags, Saving, and Imports
Reduce the Size of the Multiplier
• In addition, savings and money spent on
import goods (which are not part of AD
for domestically produced goods and
services) reduces the size of the
multiplier since each of them reduces the
fraction of a given increase in income
that will go to additional purchases of
domestically produced consumption
goods.
89
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Time Lags, Saving, and Imports
Reduce the Size of the Multiplier
• Note that the multiplier effect is not
restricted to changes in government
purchases and taxes.
• It can apply to changes that alter spending
in any of the components of aggregate
demand: consumption, investment,
government purchases, or net exports.
90
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Time Lags, Saving, and Imports
Reduce the Size of the Multiplier
• Also, the multiplier is most effective when
it brings idle resources into production.
• If all resources are fully employed, the
expansion in demand and the multiplier
effect will lead to a higher price level, not
increases in employment and RGDP.
91
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The 2007–2009 Recession
• The 2007–2009 recession will probably end
up being the worst recession since the Great
Depression. It has lead to the largest
peacetime fiscal expansion in history.
• The Obama economists believe the multiplier
for government purchases is close to 1.6 (a
$1 billion increase in government spending
will increase a country’s GDP by $1.6 billion)
and the multiplier for taxes is closer to 1.
92
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The 2007–2009 Recession
• Other economists believe that the
multiplier is much smaller and will boost
the economy by about 20 percent of what
the Obama team expects.
• However, economists do agree that the
multiplier is very small—close to zero—
when the economy is at or near full
employment and that the effectiveness of
fiscal policy depends on the type of action
that is taken.
93
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Section 4
94
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Supply-Side Effects
of Tax Cuts
95
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Section 5
SECTION 5 QUESTIONS
96
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Supply-Side Effects of
Tax Cuts
• When policy makers discuss methods to
stabilize the economy, the traditional focus
has been on managing the economy through
demand-side policies.
• But there are economists who believe that
we should be focusing on the supply side of
the economy as well, especially in the long
run, rather than just on the demand side.
97
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Supply-Side Effects of Tax
Cuts
• In particular, they believe that when
taxes, government transfer payments
(such as welfare), and regulations are
too burdensome on productive activities,
individuals will save less, work less, and
provide less capital.
• In other words, fiscal policy can work on
the supply side of the economy as well
as the demand side.
98
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Impact of Supply-Side
Policies
• Supply-siders would encourage government
to reduce individual and business taxes,
deregulate, and increase spending on
research and development.
• Supply-siders believe that these types of
government policies could cause greater
long-term economic growth by stimulating
personal income, savings, and capital
formation.
99
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Beyond the Book: The Laffer Curve
• High tax rates could conceivably reduce work
incentives to the point that government revenues
are lower at high marginal rates of taxation than
they would be at somewhat lower rates. Economist
Arthur Laffer argued that point graphically in what
has been called the Laffer curve.
100
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Beyond the Book: The Laffer Curve
• A high marginal tax rate on the rich might reduce
the incentive to work, save, and invest, and
perhaps as important, it might produce illegal shifts
in transactions to what has been termed the
underground economy, meaning that people make
cash and barter transactions that are difficult for
any tax collector to observe. If tax evasion
becomes common, the equity and revenue-raising
efficiency of the tax system suffers, as does general
respect for the law.
101
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Research and Development and
the Supply-Side of the Economy
• Some economists believe that investment
in R&D will have long-run benefits for the
economy.
• In particular, greater R&D will lead to new
technology and knowledge, which will
permanently shift the short- and long-run
aggregate supply curves to the right.
102
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Research and Development and
the Supply-Side of the Economy
• The government encourages investments
in research and development by giving tax
breaks or subsidies to firms.
• The important fact is to concentrate on
productive research and development.
103
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How Do Supply-Side Policies Affect
Long-Run Aggregate Supply?
• Rather than being primarily concerned
with short-run economic stabilization,
supply-side policies are aimed at
increasing both the short-run and longrun aggregate supply curves.
104
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How Do Supply-Side Policies Affect
Long-Run Aggregate Supply?
• If these policies are successful and
maintained, output and employment will
increase in the long run.
• Both short- and long-run aggregate supply
will increase over time, as the effects of
deregulation and major structural changes
in plants and equipment work their way
through the economy, which takes some
time.
105
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Exhibit 14.9: The Impact of Supply-Side
Policies on Short-Run and Long-Run
Aggregate Supply
106
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Critics of Supply-Side
Economics
• Critics of supply-side economics
– Are skeptical of the magnitude of the impact of
lower taxes on work effort and of deregulation on
productivity
– Claim the 1980s tax cuts led to moderate real
output growth through a reduction in real tax
revenues, inflation, and large budget deficits
– Claim that real economic growth came as a
result of a large budget deficit
107
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Critics of Supply-Side
Economics
• They raise several questions:
– What will happen to the distribution of income
if most supply-side policies focus on benefits
to those with capital?
– Will people save and invest much more if
capital gains taxes are reduced?
108
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Critics of Supply-Side
Economics
– How much more work effort will we see if
marginal tax rates are lowered?
– Will the new production that occurs from
deregulation be enough to offset the benefits
thought by many to come from regulation?
109
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The Supply-Side and DemandSide Effects of a Tax Cut
• Tax cuts can lead to greater incentives to
work and save—an increase in AS—and
to demand-side stimulus from the
increased disposable income (income
after taxes) and an increase in AD.
• But how much will the tax rate affect
aggregate demand and aggregate
supply?
– Lets focus on the aggregate demand curve
and the SRAS curve.
110
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The Supply-Side and DemandSide Effects of a Tax Cut
• Suppose the tax cut leads to a large increase in
AD but only a small increase in SRAS. What
happens to the price level and RGDP?
• In a traditional view, the good news is that the
price level rises less than it would if there were no
supply-side effect to the tax cut.
• Without the supply-side effect from the tax cut,
the price level would rise.
111
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The Supply-Side and DemandSide Effects of a Tax Cut
• If the supply-side effect were much
larger, then, it could completely offset the
higher price-level effect of an
expansionary fiscal policy, with an
increase in RGDP, while the price level is
constant.
• Most economists agree that taxes alter
incentives and distort market outcomes.
112
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The Supply-Side and DemandSide Effects of a Tax Cut
• Taxes clearly change people’s behavior;
and the tax cuts that lead to the strongest
incentives to work, save, and invest will
lead to the greatest economic growth and
will be the least inflationary.
113
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Exhibit 14.10: Two Possible Supply-Side
Effects of a Tax Cut
114
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Section 5
115
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Automatic Stabilizers
116
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Section 6
SECTION 6 QUESTIONS
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Automatic Stabilizers
• Some changes in government transfer
payments and taxes take place
automatically as business cycle
conditions change, without deliberations
in Congress or the executive branch of
the government.
118
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Automatic Stabilizers
AUTOMATIC STABILIZERS
changes in government transfer
payments or tax collections that
automatically help counter
business cycle fluctuations
119
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How Does the Tax System
Stabilize the Economy?
• Personal income taxes vary directly with
income, and in fact, rise or fall by greater
percentage terms than income itself.
• Big increases and big decreases in GDP
are both lessened by automatic changes
in income tax receipts.
120
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How Does the Tax System
Stabilize the Economy?
• When incomes, earnings, and profits all
fall during a recession, the government
collects less in taxes.
• This reduced tax burden partially offsets
the magnitude of the recession.
• Unemployment compensation programs
become another source of automatic
stabilization.
121
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How Does the Tax System
Stabilize the Economy?
• During recessions, unemployment is
usually high and compensation payments
increase, providing income that will be
consumed by recipients.
• During boom periods, such payments will
fall as the number of unemployed
decreases.
122
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How Does the Tax System
Stabilize the Economy?
• The system of public assistance payments
tends to be another important automatic
stabilizer because the number of lowincome persons eligible for some form of
assistance grows during recessions and
declines during booms.
123
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Section 6
124
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The National Debt
125
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Section 7
SECTION 7 QUESTIONS
126
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The National Debt
• When government spending exceeds tax
revenues, a budget deficit results.
• When tax revenues are greater than
government spending, a budget surplus exists.
• A balanced budget occurs through deliberate
efforts that are a matter of public policy.
127
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How Government
Finances the Debt
• The government, when running a
budget deficit, has to have means to
fund its expenses.
• Printing more dollar bills is one solution,
but it is highly inflationary, and
undermines the confidence in the
government.
• Typically, the budget deficit is financed
by issuing debt.
128
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How Government
Finances the Debt
• The federal government borrows an amount
necessary to cover the deficit by issuing
bonds, or IOUs, payable typically at some
maturity date.
• The total of the values of all bonds
outstanding constitutes the federal debt.
129
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SOURCE: Office of Management and Budget, Historical Tables, Table 1.2, Budget of the United States Government, Fiscal
Year 2011. Washington, D.C., 2010. Available at http://www.gpoaccess.gov/usbudget/fy11/hist.html (accessed March 27, 2010).
Exhibit 14.11: Federal Budget
(Percentage of GDP)
130
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Why Run a Budget
Deficit?
• Budget deficits are important because
they provide the federal government
with the flexibility to respond
appropriately to changing economic
circumstances.
• The government may also use a budget
deficit to avert an economic downturn.
131
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Why Run a Budget Deficit?
• Historically the largest budget deficits
and a growing government debt occur
– During war years, when defense spending
escalates
– During recessions as taxes are cut and
government spending is increased
• In the 1980s, deficits and debt soared in
a relatively peaceful and prosperous
time.
132
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Why Run a Budget Deficit?
• There were huge peacetime budget deficits
and a growing national debt that continued
through early 1990s.
• After nearly a decade of uninterrupted
economic growth, a budget surplus was
recorded under the Clinton’s presidency.
• In 2001, the budget surplus slipped into a
deficit.
• Future projections suggest that the United
States will face large deficits for the next
decade.
133
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SOURCES: Office of Management and Budget, Historical Tables, Table 1.2, Budget of the United States Government, Fiscal Year 2011.
Washington, D.C., 2010. Available at http://www.gpoaccess.gov/usbudget/fy11/hist.html (accessed March 27, 2010); Congressional Budget
Office, An Analysis of the President’s Budgetary Proposals for Fiscal Year 2011, Tables 1-1 and 1-2, Washington, D.C., March 2010.
Available at http://www.cbo.gov/ftpdocs/112xx/doc11280/03-24-apb.pdf (accessed March 31, 2010).
Exhibit 14.12: A Preliminary Analysis of the
President’s Budget and an Update of CBO’s
Budget and Economic Outlook
134
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An Increase in the Budget Deficit:
Short-Run and Long-Run Effects
• When the government borrows to finance
a budget deficit, it causes the interest to
rise, which crowds out private
investment, reducing capital formation.
• However, what if the government runs a
budget deficit reduction (or surplus)?
135
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An Increase in the Budget Deficit:
Short-Run and Long-Run Effects
• In the short run, deficit reduction will result
either in tax increases and/or a reduction in
government purchases will shift the AD
curve to the left.
• Unless this shift is offset by expansionary
monetary policy, a lower price level and
lower RGDP will result.
• Hence, in the short run, an aggressive
program of deficit reduction can lead to a
recession.
136
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Exhibit 14.13: Reducing a Budget Deficit—
The Short-Run Effects
137
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An Increase in the Budget Deficit:
Short-Run and Long-Run Effects
• In the long run, lowering the budget deficit
leads to a lower real interest rate,
increasing private investment and
stimulating higher growth in capital
formation and economic growth.
– In the 1990s, the reduction in the deficit
increased the potential rate of output, shifting
the SRAS and LRAS curves rightward.
138
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An Increase in the Budget Deficit:
Short-Run and Long-Run Effects
– The final effect was a higher RGDP and a
lower price level than would have
otherwise prevailed.
– Both investment and RGDP grew as the
budget deficit shrank.
• The long-run effects of a deficit
reduction are greater economic growth
and a lower price level, ceteris paribus.
139
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An Increase in the Budget Deficit:
Short-Run and Long-Run Effects
• The short-run recessionary effects of a
budget deficit reduction can be avoided
through the appropriate monetary
policy.
140
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Exhibit 14.14: Reducing a Budget Deficit—
The Long-Run Effects
141
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The Burden Of Public Debt
• The “burden” of the national debt is a
topic that has long interested
economists, particularly whether it falls
on present or future generations.
• Arguments can be made that the
generation of taxpayers living at the time
that the debt is issued shoulders the true
cost of the debt.
142
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SOURCE: Economic Report of the President, 2010. Statistical Tables. Table B-78 and Table B-79. Washington, D.C. February, 2010. Available at
http://www.gpoaccess.gov/eop/tables10.html (accessed March 25, 2010).
Exhibit 14.15: Public Debt Trends
143
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The Burden of Public Debt
• This is because the debt permits the
government to take command of resources
that might be available for other, private
uses.
• In a sense, the resources its takes to
purchase government bonds might take
away from private activities, such as
private investment financed by private
debt.
144
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The Burden of Public Debt
• The issuance of debt does involve some
intergenerational transfer of incomes; after
federal debt is issued, a new generation of
taxpayers is making interest payments to
persons of the generation that bought the
bonds issued to finance that debt.
145
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The Burden of Public Debt
• If public debt is created intelligently,
however, the “burden” of the debt should
be less than the benefits derived from the
resources acquired as a result.
• This is particularly true when the debt
permits an expansion in real economic
activity or for the development of vital
infrastructure for the future.
146
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The Burden of Public Debt
• The opportunity cost of expanded public
activity may also be small in terms of
private activity that must be forgone to
finance the public activity, if unemployed
resources are put to work.
• Parents can offset some of the
intergenerational debt by leaving larger
bequests.
147
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The Burden of Public Debt
• The important issue is whether the
government’s activities have benefits that
are greater than their costs; whether it is
done through raising taxes, printing money,
or running deficits is, for the most part, a
“financing issue.”
148
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Section 7
149
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