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A Lecture Presentation to accompany Exploring Economics 3 Edition by Robert L. Sexton rd Copyright © 2005 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, 3rd Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-324-26086-5 Copyright © 2002 by Thomson Learning, Inc. 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 transfer payments Copyright © 2002 by Thomson Learning, Inc. Fiscal Stimulus Affects The Budget 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. 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. When government wishes to stimulate the economy by increasing AD, it will increase government purchases of goods and services increase transfer payments lower taxes use some combination of these approaches Any of those options will increase the budget deficit (reduce budget surplus). Copyright © 2002 by Thomson Learning, Inc. Thus, expansionary fiscal policy is associated with increased government budget deficits. Copyright © 2002 by Thomson Learning, Inc. 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 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 Government: Spending and Taxation 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. Copyright © 2002 by Thomson Learning, Inc. Growth in Government In many of those years, particularly since the 1970s, the deficit was fairly substantial, often exceeding 2% 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. 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. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Generating Government Revenue Governments have to pay their bills like any person or institution that spends money. But how do they obtain revenue? Taxation Borrowing Copyright © 2002 by Thomson Learning, Inc. Types of Taxation At the federal level, most taxes or levies are on income. Most of the remaining revenues come from payroll taxes, which are levied on work-related income—payrolls. Other taxes on items like gasoline, liquor, and tobacco products provide for a small proportion of government revenues. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Customs duties, estate and gift taxes, and some minor miscellaneous taxes and other charges are also levied. The U.S. federal government relies more heavily on income-based taxes than nearly any other government in the world. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Progressive taxes are designed so that those with higher incomes pay a greater proportion of their income in taxes. Payroll taxes, which are regressive taxes, take a greater proportion of the income of lower-income groups than of higher-income groups. Copyright © 2002 by Thomson Learning, Inc. Some consider an excise tax—a sales tax on individual products such as alcohol, tobacco, and gasoline—to be the most unfair type of tax because it is generally the most regressive. Copyright © 2002 by Thomson Learning, Inc. Financing State and Local Government Activities Historically, the major source of state and local revenues has been property taxes. In recent decades, state and local governments have relied increasingly on sales and income taxes for revenues. Copyright © 2002 by Thomson Learning, Inc. 22.3 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. Changes In RGDP 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. 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 saved Copyright © 2002 by Thomson Learning, Inc. The additional consumption purchases made as a portion of the additional income is measured by the marginal propensity to consume (MPC). Copyright © 2002 by Thomson Learning, Inc. The Multiplier Effect At Work 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. Copyright © 2002 by Thomson Learning, Inc. 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. 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. 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. 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. 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. Copyright © 2002 by Thomson Learning, Inc. Changes In The MPC Affect The Multiplier Process 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. The Multiplier And The Aggregate Demand Curve 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. 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. Copyright © 2002 by Thomson Learning, Inc. Time Lags, Saving, Taxes, And Imports Reduce The Size Of The Multiplier 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. 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. 22.4 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. Copyright © 2002 by Thomson Learning, Inc. Budget Deficits And Fiscal Policy 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. 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. If the government decides to purchase more cut taxes 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. Copyright © 2002 by Thomson Learning, Inc. 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 AD, ideally to a new short-run equilibrium at potential RGDP. The result of such a change would be an increase in the price level and an increase in RGDP. Copyright © 2002 by Thomson Learning, Inc. 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. 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. 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. Copyright © 2002 by Thomson Learning, Inc. The higher costs that result from these input price increases will shift the short-run 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. Budget Surpluses (Or Budget Deficit Reductions) And Fiscal Policy 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. Copyright © 2002 by Thomson Learning, Inc. 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. 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. 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 full-employment output; a new shortand long-run equilibrium. Copyright © 2002 by Thomson Learning, Inc. Now consider the case of an initial short- and long-run equilibrium at full employment, where AD intersects both the SRAS and LRAS curves. 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 fullemployment level. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. 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. How Does The Tax System Stabilize The Economy? 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. 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. Other income-related payroll taxes act as automatic stabilizers, notably Social Security taxes corporate profit tax unemployment compensation program Copyright © 2002 by Thomson Learning, Inc. 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. 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 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. Copyright © 2002 by Thomson Learning, Inc. The Crowding-Out Effect 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. Copyright © 2002 by Thomson Learning, Inc. 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 crowdingout effect. Copyright © 2002 by Thomson Learning, Inc. 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 ratesensitive purchases at the same time. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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). Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Time Lags In Fiscal Policy Implementation 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. Government tax or spending (fiscal policy) changes require both congressional and presidential approval. Suppose the economy is beginning a downturn. Copyright © 2002 by Thomson Learning, Inc. 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). Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. 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. 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. 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. Timed correctly, contractionary fiscal policy could correct an inflationary boom. Timed incorrectly, it could cause a recession. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. 22.7 Supply-Side Fiscal Policy 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. What Is Supply-Side Fiscal Policy? 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. Impact Of Supply-Side Policies 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. 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. 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. 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. 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. 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. The Laffer Curve 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 after-tax earnings. Copyright © 2002 by Thomson Learning, Inc. 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. 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. Higher marginal tax rates will also lead investors to spend more scarce resources looking for tax shelters, which harms the economy, as highreturn 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. 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. Copyright © 2002 by Thomson Learning, Inc. 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. A very high marginal tax rate on the rich actually might reduce the incentive to work save invest produce 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. 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. Research And Development And The Supply-Side Of The Economy 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. The government encourages investments in research and development by giving tax breaks or subsidies to firms. Copyright © 2002 by Thomson Learning, Inc. How Do Supply-Side Policies Affect Long-Run Aggregate Supply? Rather than being primarily concerned with short-run economic stabilization, supply-side policies are aimed at increasing both the shortrun and long-run aggregate supply curves. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. Critics Of 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. The Supply-Side And DemandSide Effects Of A Tax Cut 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. 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. 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. 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. Copyright © 2002 by Thomson Learning, Inc. 22.8 The National Debt Historically the largest budget deficits and a growing government debt occur during war years, when defense spending escalates 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. How Government Finances The 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. 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. 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. 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. Copyright © 2002 by Thomson Learning, Inc. Why Run A Budget Deficit? 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. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. The Burden Of Public 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. 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. 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. 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. 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. Parents can offset some of the intergenerational debt by leaving larger bequests. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc.
