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Fiscal Policy:
Taxes, Spending,
and the Federal Budget
© 2003 South-Western/Thomson Learning
Spending, Taxes, and the
Budget
When examining budget-related
figures over time,
• it is grossly misleading to use
nominal figures, since
• the price level rises over time.
Spending, Taxes, and the
Budget
Spending and debt should be
considered relative to total income.
This is why we should always look at
these figures as percentages of GDP.
Spending, Taxes, and the Budget
•Government Spending
•Federal Tax Revenues
•The Federal Budget and the
National Debt
Government Spending
Three Categories of Government
Spending
•Government Purchases
•Transfer Payments
•Interest on the National Debt
Government Spending
Purchases/ 14%
GDP
12%
Total Governmennt Purchases
10%
8%
6%
Military Purchases
4%
2%
Non-military Purchases
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
Year
Government Purchases
As a percentage of GDP, non-military
government purchases have remained
very low and stable and have not
contributed to growth in total
government spending.
Government Purchases
As a percentage of GDP, military
purchases have declined dramatically
over the past several decades and have
not contributed to any growth in
government spending.
Government Purchases
The decline in military spending in
relation to GDP since the early 1960s has
made huge amounts of resources
available for other purposes.
Transfer Payments
In recent decades, transfers have been
the fastest-growing part of federal
government spending and are currently
equal to about 8 percent of GDP.
Social Security and Other Transfer
Payments
Retirement
Benefits
$433 billion
Health
(Medicare
and others)
$390 billion
Income
Security
$270 billion
Total Government Spending
• Over the past several decades, and until
the early 1990s, federal government
spending as a percentage of GDP rose
steadily.
• The main causes were:
– increases in transfer payments
–increases in interest on the national debt
that exceeded the decreases in military
spending.
Total Government Spending
• From 1992 to 2000, federal government
spending as a percentage of GDP fell
steadily.
• The main causes of the decline have been:
–continued sharp decreases in military
spending
–more modest decreases in transfer payments
relative to GDP.
Federal Tax Revenues
Source
Personal income taxes
Social Security taxes
Corporate income taxes
Excise taxes
Other sources
Total
Revenue
(Billions of Dollars)
994
694
151
66
86
1,991
Personal Income Tax
Progressive Tax
A tax whose rate increases as
income increases
Personal Income Tax
Average Tax Rate
The fraction of a given income paid in
taxes.
Marginal Tax Rate
The fraction of an additional dollar of
income paid in taxes.
Social Security Tax
• The Social Security tax applies to
wage and salary income only.
• The current tax rate is a flat 15.3
percent, subject to a salary cap.
• The Social Security tax is actually the
largest tax paid by many Americans.
Other Federal Taxes
• Corporate Profits Tax
–Applies only to corporations
–Double Taxation
• Excise Taxes
Federal Revenue as a % of
GDP
Revenue/ 25%
GDP
20%
15%
Federal
Government Revenue
Income, Profit
and Excise Taxes
10%
5%
Social Security
Taxes
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
Year
The Federal Budget and the
National Debt
• Deficits - which add to the public’s
holding of government bonds - add
to the national debt.
• Surpluses - which decrease the
public’s bond holdings - subtract
from the national debt.
The Federal Budget and the
National Debt
Surplus (+) 4%
or Deficit (–), 3%
Percent of GDP
2%
1%
0%
–1%
–2%
–3%
–4%
–5%
–6%
–7%
1960
1964
1968 1972 1976 1980 1984 1988 1992 1996 2000
Year
The Federal Budget and the
National Debt
Debt/
60%
GDP
50%
40%
30%
20%
10%
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
Year
The Effects of Fiscal Changes
in the Short Run
•How Economic Fluctuations
Affect the Federal Budget
•How the Budget Affects Economic
Fluctuations
How Economic Fluctuations
Affect the Federal Budget
• In a recession, because transfers rise and
tax revenue falls, the federal budget
deficit increases (or the surplus
decreases).
• In an expansion, because transfers
decrease and tax revenue rises, the budget
deficit decreases (or the surplus
increases).
How Economic Fluctuations
Affect the Budget
Cyclical Deficit
The part of the federal budget deficit
that varies with the business cycle.
Structural Deficit
The part of the federal budget deficit
that is independent of the business cycle.
How the Budget Affects Economic
Fluctuations
• Many features of the federal tax and
transfer systems act as automatic
stabilizers.
• As the economy goes into a recession,
these features
– help to reduce the decline in
consumption spending
– also cause the cyclical deficit to rise
How the Budget Affects Economic
Fluctuations
• As the economy goes into an expansion,
these features
–help to reduce the rise in consumption
spending
–also cause the cyclical deficit to fall
The Effects of Fiscal Changes
in the Long Run
Impact of Large and Continuing Budget Deficits
•Government continually demands loanable funds.
•Lower investment spending causes the capital
stock to grow more slowly.
•National debt - and annual interest payments on
the national debt - grow.
The Effects of Fiscal Changes
in the Long Run
Impact of Large and Continuing Budget
Surpluses
•Government continually supplies loanable
funds.
•Higher investment spending causes the
capital stock to grow more rapidly.
•National debt - and annual interest payments
on the national debt - shrink.
Is the National Debt
Dangerous?
• As long as the debt grows by the same
percentage as nominal GDP, the ratios of debt
to GDP and interest payments to GDP will
remain constant.
• In this case, the government can continue to
pay interest on its rising debt without
increasing the average tax rate in the economy.
Countercyclical Fiscal Policy
Changes in taxes or government
spending designed to counteract
economic fluctuations
Reasons Against
Countercyclical Fiscal Policy
•Timing Problems
•Irreversibility
•The Fed’s Reaction