Download Fiscal Policy

Fiscal Policy
Taxing and spending decisions by
government (Congress and
President)
I. Demand-Side Economics

Keynes: GD because neither producers nor consumers
had incentive to spend enough to cause increase in
production
– Washington Baby Sitter Co-op


Role for government: counter-cyclical—spend/cut
taxes during recession, raise taxes/cut spending during
expansion
Pump-priming
– Works best in “liquidity trap” (interest rates 0%) otherwise
monetary policy better (crowding out, inefficiencies +
disincentives)
– Political “realities”: spending easy in recession, cuts hard in
boom years procyclical policies and budget deficits + debt
(see below)
 May not actually be true: see, 1990s and 2010s
Multiplier Effect: for every one dollar change
in fiscal policy creates a greater than one dollar
change in national income
 Gov Bob  Jane  Nate  etc.

1/MPS or 1/(1-MPC)
Marginal Propensity to Save / Consume

Complex multiplier:2x
– Strongest horizontal, less intermediate, 0 vertical

Balanced Budget multiplier: 1x spending change
– So: Cutting government spending by $66B and
cutting taxes by $66B will drop GDP by $66B and
increase unemployment

Automatic Stabilizers: government
programs that change automatically
depending on GDP and personal income
(counter-cyclical)
– Transfer payments: welfare, Medicare
– Taxes (iff progressive; regressive
destabilizes)
 Progressive: more $ more % (federal income)
 Regressive: less $ more % (sales tax)
 Flat: all same %
Taxes
Inelastic
demand
consumers
pay most of
tax (e.g.
gas)
[+ inelastic
supply
Elastic
demand
producers
pay most of
tax
True Tax Burden

Lost consumer/producer surplus:
$1,000/gallon milk tax no milk
produced no tax revenue but loss
consumer/producer surplus

IF leads to reallocation to more efficient
usages, then no burden
– E.g. tax negative externalities and fund
positive externalities
II. Supply-Side Economics
Focus on Aggregate Supply and freeing up private
sector to reduce costs and shift AS right
Policy prescriptions:
 Deregulation (reduce costs + increase
competition + efficiency: false natural
monopolies)
 Adverse effects gov’t spending (esp. welfare)
 Focus disincentive effect of taxes
– Example: raising corporate taxes reduces incentive to
produce and hire
– Progressive (higher income higher %), regressive
(lower income higher %:speeding ticket, sales tax),
flat (all same %)
– Federal: progressive marginal
 Brackets

General agreement: tax cuts inc AS in
long run (but probably more AD short run)
– (disagreement costs + benefits)

Major point divergence w/in SS: Laffer
Curve + Reagonomics
“Trickledown” vs. GHWB: “Voodoo Economics”
“Dynamic” vs. “Static” scoring
Problems with Reaganomics
 1) Doesn’t work as advertised: 1980s, 2000s:
massive deficits (+ massive debt); rich don’t
invest more (a) cutting income tax encourages earning
income rather than investment, b) lack of viable
investments)
2) Top marginal tax rates already low [high 90%
in 1940s, 70% 1960, 30% 1990; Clinton tax
increase 200040%: revenue up, growth up
(doesn’t disprove, but seriously questions)]
rich richer, poor poorer
 3) Crisis

(you didn’t really expect nothing to ever go wrong did you
Pollyana?)

4) Efficiency can be the enemy of stability (and growth in
the long run: static efficiency vs. creative destruction)
Econ 101 Works

Expansionary fiscal policy is expansionary;
contractionary fiscal policy is
contractionary
Gross Domestic Product: Measure of national wealth
Post-WWII GDP Growth by
Administration
•
•
•
•
•
#1: Kennedy-Johnson
(49 percent over eight
years)
#2: Clinton (34 percent)
#3: Reagan (32 percent)
#4: Nixon-Ford (24
percent)
#5: Eisenhower (21
percent)
P
Avg%
GDP
growth
by year
(3)
Truman
3.9
(9) Ford
2.55
(7) Ike
2.97
(6)
Carter
3.3
(2) JFK
4.65
(5)
Reagan
3.41
(1) LBJ 5.05
(11)GH
WB
2.125
(8) RMN 2.883
(4)
Clinton
3.725
(10)
GWB
2.51
Real Income Growth, 1979-89
Why doesn’t work?

Marginal Propensity to Consume (MPC) vs. Marginal
Propensity to Save (MPS)
– MPC .75 $6.67 B to increase AD $5B
 $1.67 in S

If tax cut goes to wealthy, MPC even lower tax cut must
be even larger
– 2003 tax cuts: $726 B in cuts to create 1.4 million jobs
– 726/1.4= little over $500,000
– Average US job pays $40,000 x 10 years= $400,000
 Actual job creation: 0 (would have been negative even before
recession except for public sector growth)

Well, what about savings and investment?
– US savings rate practically 0, if not negative
–  “Supply-side” tax cuts primarily effect demand (C+I), especially
in short term

Also, Federal tax cuts less money to States (e.g.
education, Medicare) spending cuts (AD) or tax
increase (regressive State taxes, AD; “50 Herbert
Hoovers”)
Lucky Duckies

Wall Street Journal Op-ed (Nov 2002): tax system creates 2 classes:
those who pay huge taxes and those who pay none (don’t have
“blood boiling with tax rage”)  don’t see costs of gov’t don’t
support “tax relief”
– Top 50% pay 96% of federal income taxes
– Top 5% pay 56% of federal income taxes
– + Earned Income Tax Credit (EITC): compromise in 1996 Welfare
Reform act



“Say a person earns $12,000. After subtracting the personal
exemption, the standard deduction and assuming no tax credits,
then applying the 10% rate of the lowest bracket, the person ends
up paying a little less than 4% of income in [Federal income] taxes.
It ain't peanuts, but not enough to get his or her blood boiling with
tax rage.”
“Workers who pay little or no taxes can hardly be expected to care
about tax relief for everybody else. They are also that much more
detached from recognizing the costs of government.” (vote
Democratic)
Suggestion: should raise taxes on the poor to get them to vote for
“tax relief” (vote Republican)
– http://luckyduckies.blogspot.com/2004/11/wall-street-journal-lucky-duckies.html
But…
1) Poor people vote much lower rate
 2) The rich benefit more from gov’t: over
$100,000 got $9,280 in benefits; under $10,000
got $5,560 (in 1992, probably worse now)

– Whole argument for progressive taxes to begin with:
William Jennings Bryan (1894)—"Who is it most
needs a navy? Is it the farmer who plods along
behind the plow upon his farm, or is it the man
whose property is situated in some great seaport
where it could be reached by an enemy's guns?"

3) Tax code isn’t progressive when add all taxes
III. The Budget

Deficit: the amount the government
spends more than it takes in (2010 $1.4
trillion; 2013 $680 billion)
– Surplus: takes in more than spends

Debt: all the money the federal
government owes to bondholders (2013:
$17 trillion; mostly to US citizens)
Problems with Debt / Deficit

1) Crowding-out: investment in
government bonds means less money
available for private investment
– Unless: a) money wasn’t going to be
borrowed/invested anyway (GD), or b) Fed
easy money (offsets IR up; “zero lower
bound”: 2007 on)
If the government deficit spends, where does
it get the money? It must borrow in the
Loanable Funds Market.
Slf
What
demand
As theentities
government
i1
money
inmoney
the loanable
borrows
in
funds
market?
the
loanable
funds
Dlf1
i
market,
money
Households
demand increases
Dlf
Firms
Q causing interest rates
Loanable Funds
to Government
go up.
Slf
i1
i
Dlf1
Dlf
Q
Loanable Funds
Higher interest rates
crowd out private
borrowing that
would have occurred
at the lower interest
rate.
2) Servicing the debt: interest payments
 3) Deficit inflation higher interest
rates slower economy less tax
revenue more deficit
 4) Default? How secure are US bonds?
$45 trillion Medicare and Social Security
“debt”

– (add up future deficits, discount to today’s $s)
But…
Net Exports Effect

Crowding-out higher IR greater
demand US financial assets (bonds,
savings accounts, etc.) greater demand
US $ $ value up US goods more
expensive compared foreign goods
(foreign cheaper) exports down +
imports up GDP down (partially offsets
expansionary policy)