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Fiscal and Monetary Policy Effects Outline: 1. What is fiscal and monetary policy and how do they work? 2. The Federal Budget 3. Principles of taxation 4. The automatic stabilizers 16 Federal, State & Local Government Spending as a Percent of GDP www.economagic.com 14 12 10 8 6 4 2 50 55 60 65 70 75 State and Local 80 85 Federal 90 95 00 Fiscal Policy Fiscal policy is the use of the federal budget to smooth the business cycle and encourage economic growth. The Employment Act of 1946 establishes a responsibility for the Federal government to “promote maximum employment, production, and purchasing power. The Federal Budget The Federal budget is an annual statement of expenditures, tax receipts, and surplus or deficit of the government of the U.S. Let: •G denote federal spending for goods and services in a fiscal year (Oct. 1 thru Sept. 30). •TX is federal tax receipts. •TR is federal transfer payments. •T is federal net taxes (TX - TR) If G exceeds T in a fiscal year, then we have a federal deficit. If, however, T exceeds G, then we have a federal surplus. Federal Outlays and Tax Receipts, 1978-2002 (in millions of dollars) 2500000 www.economagic.com 2000000 1500000 1000000 500000 0 78 80 82 84 86 88 OUTLAYS 90 92 94 96 98 RECEIPT S 00 02 How Fiscal Policy Works AE AE2 AE1 Y 1 G (1 MPC MPI MTR) G Full employment GDP 0 Y1 YFE Real GDP The preceding slide illustrates the type of expansionary fiscal policy that Keynesians recommend for recession. We will now use the AS-AD framework to illustrate contractionary fiscal policy. Modeling Expansionary Fiscal Policy Price Level Potential GDP AS AD2 AD1 0 Y1 Real GDP Question: How is Fed policy “transmitted” to macroeconomic variables such as real GDP, employment, and the general price level? Fed Open Market Purchase of Securities Increase in the Money Supply Decrease in the interest rate Increase in components of spending that are sensitive to interest rates—specifically, investment and consumer durable goods Multiplier Effect Real GDP Nominal Interest Rate (%) Diagrammatic explanation of the transmission mechanism MS1 MS2 6% AE AE2 AE1 C I 4% Md 0 Money 450 0 Y1 1 Y (C I ) (1 MPC MPI MTR ) Y2 Real GDP The Fed pulled on the string big time beginning in 1979—it was an anti-inflation strategy under Chairman Paul Volcker Modeling Contractionary Monetary Policy Price Level Potential GDP AS AD2 AD1 0 Y1 Real GDP 20 Recessions are shaded 18 16 14 12 10 8 79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01 Federal Funds 20 Recessions are shaded Conventional 30 year 18 16 14 12 10 8 6 80 82 www.economagic.com 84 86 88 Mortgage Interest Rates 90 92 Monthly payments on a $110,000 30 year mortgage note Mortgage rate Monthly Payment1 8% $807.14 10% $965.33 12% $1,131.47 14% $1,303.36 16% $1,479.23 1 Does not include prorated insurance or property taxes. 2400 Recessions are shaded Data in thousands of units 2000 1600 1200 800 400 80 www.economagic.gov 82 84 86 88 Monthly Housing Starts 90 92 More recently, the Fed raised the federal funds rate six times between May 99 and May 2000— from 4.75% to 6.5 %. The Fed reversed course at the beginning of 2001 and reduced the federal funds rate 11 times that year! Principles of Taxation •Horizontal equity: Tax code should be written so that those in the same economic circumstances pay the same amount in taxes. •Vertical equity: Tax code should be written so that those in different economic circumstances should pay an unequal amount in taxes. •Benefits received principle: Those who derive more benefits from government programs should pay more taxes. •Taxable income: Gross income - income exempt from taxes. Example: For single filers who use the 1040EZ: Gross Income: $35,000 Minus: Standard deduction 7,050 Equals: Taxable income $27,950 •Average tax rate (ATR): Tax payments as a percent of taxable income. •Marginal tax rate (MTR): The tax rate applied to the last dollar of taxable income. •Progressive tax: The proportion of taxable income taken in taxes increases as taxable income increases. •Regressive tax: The proportion of taxable income taken in taxes decreases as taxable income increases. •Proportional tax: The proportion of taxable income taken in taxes remains constant as taxable income increases. Needy By making the tax structure “progressive,” governments can make the after-tax distribution of income more equitable (or even). Affluent Federal personal Income Tax rates Under the 1993 Tax Reform Act (Married couple filing jointly) Total Taxable Income Marginal Tax Rate (%) $0 0% 0-36,900 36,901-89,150 15 28 89,151-140,000 31 140,001-250,000 36 250,000 and up 39.6 Average and Marginal Tax Rates under the Tax Reform Act of 1993 (for a couple with 2 children) Income $10,000 20,000 30,000 50,000 75,000 150,000 250,000 400,000 Tax $0 272 1,766 4,766 10,315 32,140 66,802 128,710 Ave. Tax Rate Marginal Tax Rate 0% 0% 1.4 15 5.9 15 9.5 15 13.8 28 21.4 31 26.7 36 32.2 39.6 Tax Brackets for 2003 under the 2001 Tax Reform Act 2003 Taxable Income Marginal Tax Rate $0-$12,000 10.0% $12,000-$47,500 15.0 $47,500-$114,650 27.0 $114,650-$174,700 30.0 $174,700-$311,950 35.0 Over $311,950 38.6 Source : Wall Street Journal Quick Facts about President Bush’s Tax Bill •The current 39.6% tax rate drops to 33% •The current 36% tax rate drops to 33% •The current 31% rate drops to 25% •The current 28% rate drops to 25% •The current 15% bracket is retained over most of its range •A new 10% bracket applies to the lowest ¼ of the current 15% range. President Bush comments (wav) Assume a 7.13 percent excise tax on groceries, gasoline, cigarettes, and liquor (1) Family Income (2) Spending for items subject to excise tax (3) = (2)/(1) (4) (5)= (4)/(1) Greens $27,000 $16,200 .60 $1,188 4.4% Jones 64,000 25,600 .40 1,871 2.9 Lemons 270,000 40,500 .15 2,961 1.0 Excise Tax Paid ATR Moral of the story: Low income families tend to spend a greater proportion of their income on items subject to excise taxes. Hence excise taxes tend to be regressive. Automatic Stabilizers Taxes (TX) and Transfer Payments (TR) are called “automatic stabilizers” because they react to changes in national income in a way that increases the federal deficit (or reduces the surplus) in the event of an economic contraction or reduces the deficit (increases the surplus) when the economy is expanding. The automatic stabilizers make sure that disposable income (DI) does not fall too much when national income is falling, and vice-versa. Remember that the federal deficit or surplus is equal to the difference between G and Net Tax Receipts, where Net Taxes are equal to TX - TR YTX, for example YTX, and vice versa YTR, for example YTR, and vice versa Note that claims for unemployment compensation and other assistance surges when unemployment rises. G, T Potential GDP T = TX - TR G Deficit 0 Balanced budget at full-employment Y1 Real GDP In the case of a federal deficit, the Treasury must borrow. The national debt is the accumulated borrowing of the federal government in all previous fiscal years, minus what has been repaid Is a large national debt a bad thing? Arguments against a large national debt include: •The “burden on future generations” argument. •A large national debt means that a significant share of federal spending must be allocated for interest payments—leaving less for other priorities. •A large national debt makes the U.S. too dependent on foreign financial inflows. •Federal borrowing “crowds out” private sector borrowing units—i.e., firms and households. “[W]e (the U.S.) owe $5.7 trillion in debt and if we don’t pay it off, our children and our grandchildren are going to have to.” Congressman Marion Berry, in a speech to the Jonesboro Lions Club on April 16, 2001. Interest as a Percent of Federal Outlays 16 14 12 10 8 6 4 1965 1970 1975 1980 1985 Yea r www.economagic.com 1990 1995 2000 As long as the debt grows by the same percentage as nominal GDP, the ratios of debt 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. Growth Rate of Nominal GDP and the Public Debt www.economagic.com 35 30 20 15 Growth Rate of the National Debt 10 Growth Rate of Nominal GDP 5 0 -5 Year 00 20 95 19 90 19 85 19 80 19 75 19 70 19 65 19 60 19 55 19 50 19 45 -10 19 Percent Change 25 Ratio of Gros s Federal Debt to GDP in the U.S. 1.4 1.2 1 0.8 0.6 0.4 0.2 0 19 40 19 45 19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 20 00 Debt to GDP www.bea.gov Year Who Owns the National Debt? Agencies and Trusts 1814 / 26% Privately Owned 3342 / 48% Foreign Inves tors 1271 / 18% Fed. Reserve Banks 463 / 7% Source: Federal Reserve