Download 22.4 Possible Obstacles to Effective Fiscal Policy

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Exploring Economics
Second Edition
by Robert L. Sexton
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Chapter 22
Fiscal Policy
Copyright © 2002 by Thomson Learning, Inc.
22.1 Fiscal Policy


The government can use fiscal policy to
stimulate the economy out of a
recession or to try to bring inflation
under control.
Fiscal policy alters real GDP and price
levels through



government purchases,
taxes, and
transfer payments.
Copyright © 2002 by Thomson Learning, Inc.
22.1 Fiscal Policy


When government spending (for
purchases of goods and services and
transfer payments) exceeds tax
revenues, there is a budget deficit.
When tax revenues are greater than
government spending, a budget surplus
exists.
Copyright © 2002 by Thomson Learning, Inc.
22.1 Fiscal Policy

A balanced budget, where government
expenditures equal tax revenues, may
seldom occur unless efforts are made to
deliberately balance the budget as a
matter of public policy.
Copyright © 2002 by Thomson Learning, Inc.
22.1 Fiscal Policy


In the United States, the federal
government has followed a typical
practice of running at least a modest
deficit, with large deficits in recession
years.
From 1970 to 1997, the federal budget
was in deficit every year.
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22.1 Fiscal Policy


In many of those years, particularly
since the 1970s, the deficit was fairly
substantial, often exceeding 2 percent
of GDP.
Federal government policy, until very
recently, seems to have gotten away
from the notion accepted by many
economic policy makers in earlier years
that the budget ought to be roughly
balanced over the business cycle,
running surpluses in good times and
offsetting deficits in bad times.
Copyright © 2002 by Thomson Learning, Inc.
22.1 Fiscal Policy


Fiscal restraint and a growing economy
has led to sharp improvements in the
budget deficit since 1993.
In 1998, we saw a budget surplus that
has lasted through 2001.
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22.1 Fiscal Policy

When government wishes to stimulate
the economy by increasing AD, it will





increase government purchases of goods
and services,
increase transfer payments,
lower taxes, or
use some combination of these
approaches.
Any of those options will increase the
budget deficit (reduce budget surplus).
Copyright © 2002 by Thomson Learning, Inc.
22.1 Fiscal Policy

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, or
use some combination of these
approaches.
Thus, contractionary fiscal policy, will
tend to create/expand a budget surplus,
or reduce a budget deficit, if one exists.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect

Real GDP will change any time the
amount of any one of the four forms of
purchases—consumption, investment,
government purchases, or net exports
—changes.

If, for any reason, people generally decide
to purchase more in any of these
categories out of given income, AD will
shift rightward.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect


Any one of the components of
purchases of goods and services (C, I,
G, or X – M) can initiate changes in
aggregate demand, and thus a new
short-run equilibrium.
Changes in total output are very often
brought about by alterations in
investment plans because investment
purchases are a relatively volatile
category of expenditures.
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22.2 The Multiplier Effect

However, if policy makers are unhappy
about the present short-run equilibrium
GDP, perhaps because they view
unemployment as being too high, they
can deliberately manipulate the level of
government purchases in order to
obtain a new short-run equilibrium
value.
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22.2 The Multiplier Effect


Similarly, by changing taxes or transfer
payments, they can alter the amount of
disposable income of households and
thus bring about changes in
consumption purchases.
Multiplier effect

Usually, when an initial increase in
purchases of goods or services occurs, the
ultimate increase in total purchases will
tend to be greater than the initial increase.
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22.2 The Multiplier Effect

The multiplier effect illustrated




Government spends $10 billion to buy
aircraft carriers.
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.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect

What will input owners do with this
additional income?

While behavior will vary somewhat,
collectively a substantial part of the
additional income will be
spent on additional consumption purchases,
 paid in additional taxes incurred because of the
income, and
 saved.

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22.2 The Multiplier Effect

The additional consumption purchases
made as a portion of the additional
income is measured by the marginal
propensity to consume (MPC).
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22.2 The Multiplier Effect


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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22.2 The Multiplier Effect

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.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect

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.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect


These persons, in turn, will spend some
two-thirds of their additional $6.67 billion
in income, or $4.44 billion on
consumption purchases.
This means a $4.44 billion more in
aggregate demand and income to still
another group of persons, who will then
proceed to spend two-thirds of that
amount, or $2.96 billion on consumption
purchases.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect


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 gets smaller because some
of each round’s increase in income
goes to savings and tax payments.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect


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
1
1 MPC
Copyright © 2002 by Thomson Learning, Inc.
The Multiplier Process
Change in
government purchases
$10.00 billion—direct effect on AD
First change in consumption 6.67 billion (2/3 of 10)
Second change
4.44 billion (2/3 of 6.67)
Third change
2.96 billion (2/3 of 4.44)
Fourth change
1.98 billion (2/3 of 2.98)
Fifth change
1.32 billion (2/3 of 1.98)
$30.00 billion =
Total effect on purchases (AD)
The sum of the indirect effect on AD,
through induced additional consumption
purchases, is equal to $20 billion.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect

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.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect


Because an initial increase in one of the
AD components results in greater
income, including higher profits for
suppliers, it will lead to increased
consumer purchases.
So the effect of the initial increase will
tend to have a multiplied effect on the
economy.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect

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
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.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect

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.
Copyright © 2002 by Thomson Learning, Inc.
22.2 The Multiplier Effect

In addition, savings, taxes, and money
spent on import goods (which are not
part of aggregate demand for
domestically produced goods and
services) will reduce the size of the
multiplier because each of them
reduces the fraction of a given increase
in income that will go to additional
purchases of domestically produced
consumption goods.
Copyright © 2002 by Thomson Learning, Inc.
22.3 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.




government purchases
taxes
transfer payments
Government can use fiscal policy as
either an expansionary or contractionary
tool to help control the economy, in
terms of the AD/AS model.
Copyright © 2002 by Thomson Learning, Inc.
Expansionary Fiscal Policy
LRAS
LRAS
SRAS1
PL1
E0
E1
PL0
AD1
Price Level
Price Level
SRAS0
PL2
E2
E1
PL1
PL0
E0
AD1
AD0
RGDP0 RGDPNR
RGDP
Copyright © 2002 by Thomson Learning, Inc.
AD0
RGDPNR RGDP1
RGDP
22.3 Fiscal Policy and the
AD/AS Model

When the government



purchases more,
taxes less and
increases transfer payments,
the size of the government’s budget
deficit will grow.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model


While 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 full employment.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model

If the government decides to




purchase more,
cut taxes, and/or
increase transfer payments,
other things constant, total purchases
will rise, shifting AD curve to the right.
The effect of this increase in aggregate
demand depends on the position of the
macroeconomic equilibrium prior to the
government stimulus.
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22.3 Fiscal Policy and the
AD/AS Model


Starting from an initial recession
equilibrium, with real output below
potential RGDP, an increase in
government purchases, a tax cut,
and/or increase in transfer payments
would increase the size of the budget
deficit and lead to an increase in
aggregate demand, ideally to a new
short-run equilibrium at potential RGDP.
This result of such a change would be
an increase in the price level and an
increase in RGDP.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model

Remember, of course, that much of this
increase in aggregate demand is
caused by the multiplier process, so that
the magnitude of the change in
aggregate demand will be much larger
than the magnitude of the stimulus
package of tax cuts, increases in
transfer payments, and/or government
purchases.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model

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, resulting in full employment.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the AD/AS
Model

Suppose that the economy is currently
operating at full employment.



An increase in government spending, an
increase in transfer payments, and/or a tax
cut causes an increase in AD.
Moving up along the SRAS curve, the price
level rises and real output rises as we
reach a new short-run equilibrium.
This is not a long-run (sustainable)
equilibrium. High level of AD at beyond full
capacity puts pressure on input markets,
increasing wages and input prices.
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22.3 Fiscal Policy and the
AD/AS Model


The higher costs that result from these
input price increases will shift the shortrun aggregate supply curve leftward,
until a sustainable long-run equilibrium
is reached.
Real output returns to the full
employment level, and the long-term
effect is an increase in the price level.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model



When the government purchases less,
taxes more, or decreases transfer
payments, the size of the government’s
budget deficit will fall or the size of the
budget surplus will rise, other things
equal.
Such a change in fiscal policy may help
“cool off” the economy when it has
overheated and inflation has become a
serious problem.
Then, contractionary fiscal policy has
the potential to offset an overheated,
inflationary boom.
Copyright © 2002 by Thomson Learning, Inc.
Contractionary Fiscal Policy
LRAS
LRAS
SRAS
SRAS0
E0
PL0
E1
PL1
AD0
Price Level
Price Level
SRAS1
E0
PL0
PL1
PL2
E1
E2
AD0
AD1
RGDPNR RGDP0
RGDP
Copyright © 2002 by Thomson Learning, Inc.
AD1
RGDP1 RGDPNR
RGDP
22.3 Fiscal Policy and the
AD/AS Model


Suppose the initial short-run equilibrium
is at a point beyond full-employment
output.
If the government decides to reduce its
purchases, increase taxes, or reduce
transfer payments these changes will
directly affect aggregate demand.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model

A tax increase on consumers or a
decrease in transfer payments will



reduce households’ disposable incomes,
reducing purchases of consumption goods
and services, and
higher business taxes will reduce
investment purchases.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model


The reductions in consumption,
investment, and/or government
purchases will shift the aggregate
demand curve leftward, ideally to a
long-run, full-employment level of
RGDP.
The result is a lower price level and fullemployment output; a new short- and
long-run equilibrium.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the AD/AS
Model

Now consider the case of an initial
short- and long-run equilibrium at full
employment, where AD intersects both
the SRAS curve and the LRAS curve.

A decrease in aggregate demand from that
results from a reduction in government
purchases, higher taxes, or lower transfer
payments leads to a short-run equilibrium
with lower prices and real output reduced
below its full-employment level.
Copyright © 2002 by Thomson Learning, Inc.
22.3 Fiscal Policy and the
AD/AS Model

As prices fall, input suppliers revise their
price level expectations downward.


That is, laborers and other input suppliers
are now willing to take less for the use of
their resources, and the resulting reduction
in production costs shift the short-run
supply curve right.
The resulting eventual long-run
equilibrium is a reduction in the price
level, with real output returning to its
full-employment level.
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22.4 Possible Obstacles to Effective
Fiscal Policy


The multiplier effect of an increase in
government purchases implies that the
increase in aggregate demand will tend
to be greater than the initial fiscal
stimulus, other things equal.
However, this may not be true because
all other things will not tend to stay
equal in this case.
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22.4 Possible Obstacles to Effective
Fiscal Policy


When the government borrows money
to finance a deficit, it increases the
overall demand for money in the money
market, driving interest rates up.
As a result of the higher interest rate,
consumers may decide against buying
some interest-sensitive goods, and
businesses may cancel or scale back
plans to expand or buy new capital
equipment.
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22.4 Possible Obstacles to Effective
Fiscal Policy


In short, the higher interest rate will
choke off private spending on goods
and services, and as a result, the
impact of the increase in government
purchases may be smaller than we first
assumed.
Economists call this the crowding-out
effect.
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22.4 Possible Obstacles to Effective
Fiscal Policy


An additional $10 billion of government
spending on aircraft carriers, other
things equal, would shift the aggregate
demand curve right by $10 billion times
the multiplier.
However, as this process takes place,
interest rates are bid up, crowding out
some investment and other interest
rate-sensitive purchases at the same
time.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy



By itself, this would reduce aggregate
demand by the purchases crowded out
times the multiplier.
Since both these processes are taking
place at the same time, the net effect is
the difference between the expansion of
government purchases and the private
sector purchases crowded out, times
the multiplier.
The crowding out effect also occurs with
a tax change.
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The Crowding-Out Effect
Net Effect
Price Level
LRAS
Fiscal Policy
Effect
AD0
AD2 AD1
RGDPNR
RGDP
Copyright © 2002 by Thomson Learning, Inc.
Crowding-out
Effect
22.4 Possible Obstacles to Effective
Fiscal Policy

Critics of the crowding-out effect
analysis argue that the increase in
government purchases (or tax cut),
particularly if the economy is in a severe
recession, could actually improve
consumer and business expectations
and actually encourage private
investment spending.
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22.4 Possible Obstacles to Effective
Fiscal Policy



It is also possible that the monetary
authorities could increase the money
supply to offset the higher interest rates
from the crowding-out effect.
Another form of crowding out can take
place in international markets.
Expansionary fiscal policy increases the
federal budget deficit.
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22.4 Possible Obstacles to Effective
Fiscal Policy


To finance the deficit, the U.S.
government borrows more money,
driving up the interest rate (the basic
crowding-out effect).
However, the higher interest rates will
attract funds from abroad, funds
foreigners will first have to convert from
their currencies into dollars.
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22.4 Possible Obstacles to Effective
Fiscal Policy


The increase in the demand for dollars
relative to other currencies will cause
the dollar to appreciate in value.
This will cause net exports to fall, by
making foreign imports relatively
cheaper in the United States, increasing
imports, and by making U.S.-made
goods more expensive to foreigners,
decreasing exports.
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22.4 Possible Obstacles to Effective
Fiscal Policy


This reduction in net exports causes a
fall in AD, partly crowding out the effects
of expansionary fiscal policy.
The larger the crowding-out effect, the
smaller the actual effect of a given
change in fiscal policy.
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22.4 Possible Obstacles to Effective
Fiscal Policy

Another related problem undermining
the power of fiscal policy to change
aggregate demand is expressed in what
is called the Ricardian equivalence
theorem.
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22.4 Possible Obstacles to Effective
Fiscal Policy

The argument is that an increase in
aggregate demand that would be
expected as a result of an increase in
government purchases or a current
reduction in net taxes will be partially or
fully offset by an increase in savings
(which is the same as a reduction in
consumption purchases).
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22.4 Possible Obstacles to Effective
Fiscal Policy

If people realize that the increase in
government purchases will lead to
higher taxes in the future, they may
increase their savings now to pay for
those future taxes.
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22.4 Possible Obstacles to Effective
Fiscal Policy

Thus, the expected increase in
aggregate demand as a result of an
increase in government purchases or a
decrease in net taxes is offset by the
reduction in current consumption as
individuals save for the future tax
increase.
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22.4 Possible Obstacles to Effective
Fiscal Policy

Just as with the crowding-out effect, this
implies that fiscal policy will have a
smaller effect on aggregate demand
than otherwise predicted, with the effect
smaller, the more increased current
savings (reduced current consumption)
offsets the fiscal policy stimulus.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy

The Ricardian equivalence theorem
makes intuitive sense. However,
empirical evidence of the 1980s does
not fully support the Ricardian
equivalence theory, as large budget
deficits were not accompanied with
increases in the savings rate.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy

One possible reason for the breakdown
of the theory is that individuals are
shortsighted, leading individuals to treat
the tax cut as an increase in current
income, and increase their
consumption.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy


While the theory failed to explain the
United States in the 1980s, it has held
up well in different time periods and
different countries, such as Canada and
Israel.
The verdict is still out on the Ricardian
equivalence theorem.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy


It is important to recognize that fiscal
policy is implemented through the
political process, and that process takes
time.
Often, the lag between the time that a
fiscal response is desired and the time
an appropriate policy is implemented
and its effects felt is considerable.
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22.4 Possible Obstacles to Effective
Fiscal Policy

Sometimes a fiscal policy designed to
deal with a contracting economy may
actually take effect during a period of
economic expansion, or vice versa,
resulting in a stabilization policy that
actually destabilizes the economy.
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22.4 Possible Obstacles to Effective
Fiscal Policy


Government tax or spending (fiscal
policy) changes require both
congressional and presidential
approval.
Suppose the economy is beginning a
downturn.
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22.4 Possible Obstacles to Effective
Fiscal Policy

It may take two or three months before
enough data are gathered to indicate
the actual presence of a downturn.

(Sometimes a future downturn can be
forecast through econometric models or by
looking at the index of leading indicators,
but usually decision makers are hesitant to
plan policy on the basis of forecasts that
are not always accurate).
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22.4 Possible Obstacles to Effective
Fiscal Policy

Once policy makers decide that some
policy change is necessary, there is a
consultation phase, during which many
decisions with profound political
consequences must be made, so
reaching a decision is not always easy
and usually involves much compromise
and a great deal of time.
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22.4 Possible Obstacles to Effective
Fiscal Policy


Finally, once the House and Senate
have completed their separate
deliberations and have arrived at a final
version of the bill, it is presented to
Congress for approval.
After congressional approval is secured,
the bill then goes to the president for
approval or veto.
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22.4 Possible Obstacles to Effective
Fiscal Policy



Even after fiscal policy legislation is
signed into law, it takes time to bring
about the actual fiscal stimulus desired.
If the legislation provides for a reduction
in withholding taxes, for example, it
might take a few months before the
changes actually show up in workers’
paychecks.
If it provides for changes in government
purchases, the delay is usually much
longer.
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22.4 Possible Obstacles to Effective
Fiscal Policy

If the government increases spending
for public works projects like sewer
systems, new highways, or urban
renewal, it takes time to draw up plans
and get permissions, to advertise for
bids from contractors, to get contracts,
and then to begin work.
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22.4 Possible Obstacles to Effective
Fiscal Policy



Such delays have actually lengthened in
recent years due to new government
regulations, such as environmental
impact statements, which often takes
many months or even years.
The timing of fiscal policy is crucial.
Because of the significant lags before
the fiscal policy has its effect, the
increase in aggregate demand may
occur at the wrong time.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy

In response to current low levels of
output and high rates of unemployment,
policy makers may decide to increase
government purchases and implement a
tax cut.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy

But during the period from when policy
makers recognized the problem to when
the policies had a chance to work
themselves through the economy, say
there was a large increase in business
and consumer confidence, shifting the
aggregate demand curve rightward,
increasing real GDP and employment.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy


When the fiscal policy takes effect, the
policies will have the undesired effect of
causing inflation, with little permanent
effect on output and employment.
The same timing problems exist for
fiscal policy designed to combat high
inflation rates.
Copyright © 2002 by Thomson Learning, Inc.
22.4 Possible Obstacles to Effective
Fiscal Policy


Timed correctly, contractionary fiscal
policy could correct an inflationary boom
Timed incorrectly, it could cause a
recession.
Copyright © 2002 by Thomson Learning, Inc.
Timing Expansionary Fiscal Policy
Price
LRAS
SRAS1
Level
SRAS0
E3
PL2
PL1
PL0
E2
E1
E0
AD2
AD1
AD0
RGDP0
RGDP1
RGDPNR
Copyright © 2002 by Thomson Learning, Inc.
RGDP
22.5 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.
Copyright © 2002 by Thomson Learning, Inc.
22.5 Automatic Stabilizers

Automatic stabilizers


changes in government transfer payments
or tax collections that automatically tend to
counter business cycle fluctuations
The most important automatic stabilizer is
the tax system.

With the personal income tax, as incomes rise,
tax liabilities also increase automatically.
Copyright © 2002 by Thomson Learning, Inc.
22.5 Automatic Stabilizers


Personal income taxes vary directly with
income, and in fact rise or fall by greater
percentage terms than income itself
rises or falls.
Big increases and big decreases in
GDP are both lessened by automatic
changes in income tax receipts.
Copyright © 2002 by Thomson Learning, Inc.
22.5 Automatic Stabilizers

If GDP declines, tax liabilities decline,
increasing disposable incomes and
stimulating consumption spending,
partly offsetting the initial decline in
aggregate demand.
Copyright © 2002 by Thomson Learning, Inc.
22.5 Automatic Stabilizers

Other income-related payroll taxes act
as automatic stabilizers, notably



Social Security taxes,
the corporate profit tax, and
the unemployment compensation
program.
Copyright © 2002 by Thomson Learning, Inc.
22.5 Automatic Stabilizers



Because incomes, earnings, and profits
all fall during a recession, the
government collects less in taxes.
This reduced tax burden partially offsets
any recessionary fall in aggregate
demand.
During recessions, unemployment rises
and more people become eligible for
public assistance (welfare).
Copyright © 2002 by Thomson Learning, Inc.
22.5 Automatic Stabilizers



Unemployment compensation and
public assistance payments increase.
During boom periods, such payments
will fall as the number of the
unemployed declines.
Both these tax and spending programs
act as automatic stabilizers, stimulating
aggregate demand during recessions
and reducing aggregate demand during
booms.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


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.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

In particular, they believe that when
taxes, government transfer payments
(like 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.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


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.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


Supply-siders believe that savings and
investment could be improved through
lowering taxes.
Taxes on interest earnings reduce the
after tax return to saving, which
discourages people from saving, and
the greater investment and capital
formation that would result.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics



Investment is important because
workers without capital cannot be very
productive.
Worker productivity (output per worker)
depends to a large extent on the capital
that is available to the worker.
So taxing savings and investment
heavily will reduce new capital
investment, which will reduce the
growth of worker productivity.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

Businesses might get similar relief
through investment tax credits, raising
after tax rates of return on investment,
and encouraging firms to invest in new
capital, raising worker productivity.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


It is important that government provides
certain regulations for the environment,
workers’ safety, consumer protection,
and so on.
The costs imposed on producers as a
result of these regulations have the
same effect as taxes and make goods
and services more expensive.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


Such government regulations shift the
short- and long-run aggregate supply
curves to the left because they increase
the cost of producing these goods,
which drives up prices for consumers,
and they reduce the economy’s
potential real output.
Supply-siders, therefore, support
reductions in government regulations
where the benefits don’t justify the
costs.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


Some economists emphasize the idea
that higher marginal tax rates will
discourage people from working as
much as they otherwise would.
Workers are concerned with their aftertax earnings.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

A lower marginal tax rate will raise aftertax earnings, improving productive
incentives.




It may entice more people to seek work.
It may encourage workers to postpone
their retirement.
It may mean that more workers will work
longer hours.
It could lead to more two-income families in
the labor force.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

It is also possible that the high tax rates
reduce work efforts in the legal sector
and encourage work efforts in the
underground economy instead, where
cash and barter transactions are very
difficult to observe and tax.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

Higher marginal tax rates will also lead
investors to spend more scarce
resources looking for tax shelters, which
harms the economy, as high-return but
highly taxed investments give way to
lower-return tax shelters.

An example is tax-free municipal bonds,
substituted for higher-return taxable
investments.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


High tax rates could conceivably reduce
work incentives to the point that
government revenues are lower at high
marginal tax rates than they would be at
somewhat lower rates.
Economist Arthur Laffer has argued that
point graphically in what has been
called the Laffer curve.
Copyright © 2002 by Thomson Learning, Inc.
Tax Revenues
The Laffer Curve
C
D
B
E
100%
A
0%
Tax Rate
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics



When tax rates are low, increasing the
federal tax rate will increase federal
revenues.
However, at very high federal tax rates,
disincentive effects and increased tax
evasion may actually reduce federal tax
revenue.
Over this range of tax rates, lowering
them may actually increase federal tax
revenue.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

A very high marginal tax rate on the rich
actually might





reduce the incentive to work,
save,
invest and
produce, and
perhaps as important, shift transactions to
the underground economy.

If tax evasion becomes common, the equity
and revenue-raising efficiency of the tax system
suffers, as does general respect for the law.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

While all economists believe that
incentives matter, there is considerable
disagreement on the shape of the Laffer
curve, and where the economy actually
is on the Laffer curve.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


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.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

The government encourages
investments in research and
development by giving tax breaks or
subsidies to firms.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

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.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

If these policies are successful and
maintained, both short- and long-run
aggregate supply will increase over
time, as the effects of deregulation and
major structural changes in plant and
equipment work their way through the
economy, which takes some time.
Copyright © 2002 by Thomson Learning, Inc.
The Impact of Supply-Side Policies on
Short-Run and Long-Run Aggregate Supply
LRAS0 LRAS1
SRAS0
SRAS1
PL0
E1
E0
AD1
AD0
0
RGDPNR
RGDP´NR
RGDP
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

Critics of supply-side economics

skeptical of the magnitude of the impact of
lower taxes on work effort and of
deregulation on productivity.



new production that occurs from deregulation
enough to offset the benefits of regulation?
claim the 1980s tax cuts led to moderate
real output growth through a reduction in
real tax revenues, inflation, and large
budget deficits
question amount of increased saving and
investment from reduced capital gains
taxes
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


Supply-side initiatives affect aggregate
demand as well as aggregate supply.
If tax rates are reduced, it is quite
possible that the demand-side stimulus
from the increased disposable income
that results may be equal to, or even
greater than the supply-side effects,
causing higher price levels, and even
greater short-run real output levels,
although the long-run real output level
increases with the long-run aggregate
supply curve.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics

Defenders of the supply-side approach
argue that the real tax revenues of
those in the highest marginal tax
brackets actually increased as their tax
rates fell in the 1980s (as they also had
for earlier reductions in tax rates on the
most heavily taxed high income groups)
and that, compared to other developed
countries in the world, the United States
had very prosperous growth from 1982
to 1989.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


In addition, many supply-siders argue
that most of their policy prescriptions
were never really even tried, for at least
three reasons.
First, many supply-side proposals for
improving productive incentives were
ignored, and in some cases, productive
incentives were made worse rather than
better.
Copyright © 2002 by Thomson Learning, Inc.
22.6 Supply-Side Economics


Second, the real output effects of the
initial tax cuts were minimized by the
restrictive, inflation fighting policies of
the Federal Reserve in the early 1980s.
Third, Congress did not reduce federal
expenditures, which was at least
partially responsible for the growing
deficit.
Copyright © 2002 by Thomson Learning, Inc.
Price
Price
Two Possible Supply-Side
Effects of a Tax Cut
SRAS0
SRAS0
SRAS1
PL2
PL1
PL0
SRAS1
PL0
AD1
AD0
AD0
0
RGDP0
RGDP1
Real GDP
Copyright © 2002 by Thomson Learning, Inc.
0
RGDP0
RGDP1
Real GDP
AD1
22.7 The National Debt

Historically the largest budget deficits
and a growing government debt occur



during war years, when defense spending
escalates, and
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.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt


When the government borrows to
finance a budget deficit, it causes the
interest to rise, which crowds out private
investment, reducing capital formation.
But a budget surplus adds to national
savings and lowers the interest rate,
stimulating private investment and
capital formation.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt



Policy makers now have to decide what
to do with budget surpluses.
Some favor continuing to pay down the
national debt to drive interest rates
down further and stimulate investment.
Others favor cutting taxes, to reduce
their misallocation of resources and the
temptation toward special interest
spending.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt

These raise an important question: are
we getting government goods and
services with benefits that are greater
than the costs?
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt




For many years, the government ran
continuous budget deficits and built up a
large federal debt.
How did it pay for those budget deficits?
After all, it has to have some means of
paying out the funds necessary to
support government expenditures that
are in excess of the funds derived from
tax payments.
One thing the government could do is
simply print money.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt



Printing money to finance activities is
highly inflationary and also undermines
confidence in the government.
Typically, the budget deficit is financed
by issuing debt.
The federal government in effect
borrows an amount necessary to cover
the deficit by issuing bonds, or IOUs,
payable typically at some maturity date.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt

The sum total of the values of all bonds
outstanding constitutes the federal debt.
The tendency of the federal government
to engage in budget deficits has led to
increasing federal debt over time.
Copyright © 2002 by Thomson Learning, Inc.
New Federal Budget Balance, 1970–2001
Billions of dollars
$300
$200
$100
$0
$ –100
$ –200
$ –300
$ –400
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000
Year
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt


From 1960 through 1997, the federal
budget was in deficit every year except
one.
They can be important because they
provide the federal government with the
flexibility to respond appropriately to
changing circumstances, such as
special emergencies or to avert an
economic downturn.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt

The “burden” of the national debt is a
topic that has long interested
economists, particularly whether it falls
on present or future generations.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt

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 because the
debt permits the government to take
command of resources that might be
available for other, private uses.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt


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.
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.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National 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.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National 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.
There is also the possibility of
Ricardian equivalence.
Parents can offset some of the
intergenerational debt by leaving larger
bequests.
Copyright © 2002 by Thomson Learning, Inc.
Public Debt, Federal Government,
Selected Years
Fiscal Year
1929
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2002*
Public Debt
Public Debt as a
(billions of dollars) Percentage of GDP
$16.9
43.0
260.2
256.8
274.4
290.5
322.3
380.9
541.9
909.1
1,817.5
3,206.6
4,921.0
5,629.0
5,663.7
*estimate
SOURCE: Office of Management and Budget, 2000.
Copyright © 2002 by Thomson Learning, Inc.
18.%
45
120
94
69
56
47
38
35
33
44
56
67.2
57.3
52.2
22.7 The National Debt

If they save now to bear the cost of the
burden of future taxes, the reduced
consumption and increased savings will
lower interest rates, or, more precisely,
offset some or all of the higher interest
rates caused by the government deficit.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt


How would Ricardian equivalence work
with a budget surplus?
If a budget deficit led people to believe
there would be higher future taxes, a
budget surplus would lead them to think
that there would be lower future taxes,
perhaps saving less and consuming
more.
Copyright © 2002 by Thomson Learning, Inc.