Download Fiscal policy

Fiscal policy refers to the use of the spending and
taxing powers of the federal government to manage
aggregate demand, and thereby to stabilize the level
of output, employment, and prices.
Under the Employment Act of
1946, the Federal government is
to promote “maximum
production, employment ,
and purchasing power.”
Yf is potential
GDP
AE = Y
AE
AE2
AE1
G
Here we
illustrate the
use of G to
stimulate AE and
push the economy
to full-employment
Y
Y*
Y = G 
Y
Yf
1
1-c+m
If Madonna or Bill Gates
paid the same amount
in taxes as an accountant
or government employee,
that would be vertically
inequitable
•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.
•Ability to pay principle: Those with greater
ability to pay taxes should pay more.
•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:
$30,000
Minus:
Standard deduction
6,250
Equals:
Taxable income
$23,750
•Average tax rate (ATR): Tax payments as a percent of taxable
income.
•Marginal tax rate (MTR): The tax rate applied to the last
dollar of taxable income.
Note that ATR
Family
Taxable income ($)
Taxes
ATR
Smiths
$17,500
$2,655
15%
Cunninghams 54,000
10,322.72
19.12
Zappas
41,313.49
26.15
158,000
and taxable
income move in
same direction
A progressive tax, such as the
federal personal income tax upon which this
example is based, is generally
consistent with the principle of vertical equity
Family
Taxes ($)
ATR
$5,075
29%
Cunninghams 54,000
14,040
26
Zappas
37,920
24
Smiths
Taxable
income
($)
$17,500
158,000
Payroll and sales
taxes on grocery
items, beer, and
cigarettes are
regressive
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
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 YD does not
fall too much
when national income
is falling
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
YTX, for example
YTX, and vice versa
YTR, for example
YTR, and vice versa
Note that claims for
unemployment
compensation and other
assistance surges when
unemployment rises.
YR is the recession-level of
national income
G, T
Fullemployment
T = TX - TR
G
Deficit
0
YR
National Income
Let:
• AE denote aggregate demand
• Y is real GDP
•TX is tax payments
•TR is transfer payments
•YD is personal disposable income
Thus, in a closed economy we have:
AE = C + I + G
[1]
It is also true that:
YD = Y - TX + TR [2]
The full-employment model
suggests that an increase in G
must result in a compensating
decrease in C or I--this is the
“crowding out” effect
Government can increase YD by decreasing TX or increasing
TR (reverse also holds true). Economists call transfer payments
“negative taxes.”
Increased government spending crowds out
investment
 Allow for an
increase in G finance
by increased taxes
(TX). Note that:
YD
= Y - TX + TR
S function shifts left
due to decrease in
YD
Interest rate (r)
r2
r1
0
Investment
function
I1
I2
Crowding out
S, I