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C h a p t e r
11
FISCAL POLICY
O u t l i n e
Balancing Acts on Capitol Hill
A. In 2003, the federal government planned to spend 18 cents
out of each dollar earned in the United States, and
collect nearly as much in taxes. How does that affect the
economy?
B. For most of the 1980s and 1990s, the government ran
deficits, to the extent that the national debt is now
about $12,000 per person. What are its effects, and how
can deficits be avoided?
I.
The Federal Budget
A. The federal budget is the annual statement of the federal
government’s expenditures and tax revenues. Fiscal policy is
the use of the federal budget to achieve macroeconomic
objectives, such as full employment, sustained long-term
economic growth, and price level stability.
B. The Institutions and Laws
1. Fiscal policy is made by the president and Congress.
Figure 26.1 (page 604/258) illustrates the timeline.
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2. Fiscal policy operates within the framework of the
Employment Act of 1946, which committed the government to
work toward “maximum employment, production, and
purchasing power.”
3. The President’s Council of Economic Advisers monitors the
economy and advises the President on economic policy.
C. Highlights of the 2003 Budget
1. Table 26.1 (page 605/259) summarizes the projected
fiscal 2003 Federal Budget and shows the shows tax
revenues, expenditures, and a projected surplus.
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2. Tax revenues come from personal income taxes, social
insurance taxes, corporate income taxes, and indirect
taxes. Personal income taxes followed by social
insurance taxes are the two largest revenue sources.
3. Expenditures are classified as transfer payments,
purchases of goods and services, and debt interest.
Transfer payments are by far the largest expenditure,
and are sources of persistent growth in expenditures.
4. The federal government’s budget balance equals tax
revenue minus expenditure. If tax revenues exceed
expenditures, the government has a budget surplus. If
expenditures exceed tax revenues, the government has a
budget deficit. If tax revenues equal expenditures, the
government has a balanced budget.
D. The Budget in Historical Perspective
1. Figure 26.2 (page 606/260) shows the government’s tax
revenues, expenditures, and budget surplus or deficit
as a percentage of GDP for the period 1983–2003. The
government had a deficit of 5.2 percent in 1983. The
deficit declined and in 1998 to 2001, the government
had a surplus. A deficit arose again in 2002 and 2003.
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2. Figure 26.3 (page 607/261) shows the evolution of the
components of tax revenues and expenditures as a
percentage of GDP over the period 1983–2003. Tax
revenues increased and expenditures decreased.
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3. Government debt is the total amount that the government
has borrowed—that the government owes. It is the
accumulation of all past deficits. Figure 26.4 (page
608/262) shows the evolution of the debt as a
percentage of GDP since 1942.
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4. The debt to GDP ratio reached a peak at the end of
World War II in 1945. It then generally fell until
1974. From 1974 to 1992 the ratio rose; it then fell
from 1992 to 2002, when it started to increase again.
E. The U.S. Government Budget in Global Perspective
1. Figure 26.5 (page 263) compares government budget
deficits around the world in 2001.
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2. The world as a whole that year had a government budget
deficit of about 1.5 percent of world GDP.
F. State and Local Budgets
1. In 2001, when the federal government spent $1,900
billion, state and local governments spent about
$1,300 billion, mostly on education, protective
services, and roads.
2. State and local budgets are not used for stabilization
purposes, and occasionally are destabilizing in
recessions.
II. Fiscal Policy Multipliers
A. Automatic fiscal policy is a change in fiscal policy triggered
by the state of the economy. Discretionary fiscal policy is a
policy action that is initiated by an act of Congress.
1. To enable us to focus on the principles of fiscal
policy multipliers, we first study discretionary
fiscal policy in a model economy that has only lumpsum taxes.
2. Lump-sum taxes are taxes that do not vary with real
GDP.
B. The Government Purchases Multiplier
1. The government purchases multiplier is the magnification
effect of a change in government purchases of goods
and services on equilibrium aggregate expenditure and
real GDP.
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2. A multiplier exists because government purchases are a
component of aggregate expenditure; an increase in
government purchases increases aggregate income, which
induces additional consumption expenditure.
3. Table 26.2 (page 611/265) illustrates the government
purchases multiplier with a numerical
example.
4. Figure 26.6 (page 612/266) illustrates the government
purchases multiplier in the aggregate expenditure
diagram.
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a) An $0.5 trillion increase in government purchases
shifts the aggregate expenditure curve upward from
AE0 to AE1 and equilibrium expenditure increases by
$2 trillion.
b) The government purchases multiplier is 1/(1 – MPC)
where MPC is the marginal propensity to consume
(absent induced taxes and imports).
C. The Lump-Sum Tax Multiplier
1. The lump-sum tax multiplier is the magnification effect a
change in lump-sum taxes on equilibrium aggregate
expenditure and real GDP.
2. An increase in lump-sum taxes decreases disposable
income, which decreases consumption expenditure and
decreases aggregate expenditure and real GDP.
3. The amount by which a tax increase lowers consumption
expenditure is determined by the MPC. A $1 tax
increases lowers consumption expenditure by $1  MPC,
and this amount gets multiplied by the standard
autonomous expenditures multiplier.
4. The lump-sum tax multiplier is –MPC/(1 – MPC)
It is negative because an increase in lump-sum taxes
decreases equilibrium expenditure.
5. Figure 26.7 (page 613/267) illustrates the effect of
an increase in lump-sum taxes. A tax increase shifts
the AE curve downward and equilibrium expenditure and
real GDP fall.
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6. The lump-sum transfer payments multiplier and the
lump-sum tax multiplier are the same except for their
signs—the transfer payments multiplier is positive.
D. Induced Taxes and Entitlement Spending
1. Taxes that vary with real GDP are called induced taxes.
Most transfer payments are entitlement spending, which
also vary with real GDP.
2. During a
spending
rise and
diminish
lump-sum
recession, induced taxes fall and entitlement
rises; and during an expansion, induced taxes
entitlement spending falls. Both effects
the size of the government purchases and
tax multipliers.
3. The extent to which induced taxes and entitlement
spending decrease the multiplier depends on the
marginal tax rate, which is the fraction of an
additional dollar of real GDP that flows to the
government in net taxes.
4. The higher the marginal tax rate, the larger is the
fraction of an additional dollar of income that flows
to the government and the smaller is the induced
change in consumption expenditure. The smaller the
induced change in consumption expenditure the smaller
are the government purchases and lump-sum tax
multipliers.
E. International Trade and Fiscal Policy Multipliers
1. Imports decrease the fiscal policy multipliers.
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2. The larger the marginal propensity to import, the
smaller is the magnitude of the government purchases
and lump-sum tax multipliers.
F. Automatic Stabilizers
1. Automatic stabilizers are mechanisms that stabilize real
GDP without explicit action by the government. Income
taxes and transfer payments are automatic stabilizers.
2. Because income taxes and transfer payments change with
the business cycle, the government’s budget deficit
also varies with this cycle. In a recession, taxes
fall, transfer payments rise, and the deficit grows;
in an expansion, taxes rise, transfers fall, and
deficit shrinks.
3. Figure 26.8 (page 614/268) shows the budget deficit
over the business cycle for 1981–2001.
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4. The structural surplus or deficit is the surplus or deficit
that would occur if the economy were at full
employment and real GDP were equal to potential GDP.
The cyclical surplus or deficit is the actual surplus or
deficit minus the structural surplus or deficit; that
is, it is the surplus or deficit that occurs purely
because real GDP does not equal potential GDP. Figure
26.9 (page 615/269) illustrates these ideas.
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III. Fiscal Policy Multipliers and the Price Level
A. Fiscal Policy and Aggregate Demand
1. Figure 26.10 (page 617/271) illustrates the effects of
fiscal policy on aggregate demand.
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2. An increase in government purchases shifts the AE
curve upward and shifts the AD curve rightward. The
magnitude of the shift in the AD curve equals the
government purchases multiplier times the increase in
government purchases. When lump-sum taxes decrease,
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the rightward shift in the AD curve equals the lumpsum tax multiplier times the reduction in taxes.
a) Expansionary fiscal policy, an increase in government
expenditures or a decrease in tax revenues, shifts
the AD curve rightward.
b) Contractionary fiscal policy, a decrease in government
expenditures or an increase in tax revenues, shifts
the AD curve leftward.
3. Figure 26.11a (page 618/272) illustrates the effect of
an expansionary fiscal policy on real GDP and the
price level when real GDP is below potential GDP.
a) The rightward shift in the AD curve equals the
multiplied increase in aggregate expenditure.
b) The increase in GDP is less than the multiplied
increase in aggregate expenditure because the price
level rises.
B. Fiscal Expansion at Potential GDP
1. In Figure 26.11b (page 618/272) illustrates the
effects of an expansionary fiscal policy at full
employment.
2. In the long run, fiscal policy multipliers are zero
because real GDP equals potential GDP and a change in
aggregate demand changes the money wage rate, the SAS
curve, and the price level.
C. Limitations of Fiscal Policy
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1. Because the short-run fiscal policy multipliers are
not zero, fiscal policy can be used to help stabilize
the economy.
2. But in practice, fiscal policy is hard to use because:
a)
The legislative process is too slow to permit
policy actions to be implemented when they are
needed.
b) Potential GDP is hard to estimate, so too much
fiscal stimulation might be applied too close to
full employment.
IV. Supply Side Effects of Fiscal Policy
A. Fiscal Policy and Potential GDP
1. Potential GDP depends on the full-employment quantity
of labor, which in turn is influenced by the income
tax. Figure 26.12 (page 620/274) illustrates the
effect of the income tax in the labor market.
a) The income tax decreases the supply of labor
because it decreases the after-tax wage rate.
b) Because the income tax decreases the supply of
labor, it raises the equilibrium wage rate,
decreases employment, and decreases potential GDP.
2. This supply-side effect of the income tax means that a
decrease in the income tax rate increases potential
GDP and increases aggregate supply.
3. Figure 26.13 (page 620/274) illustrates two views
about the effects of a tax cut on real GDP and the
price level.
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4. Everyone agrees that a tax cut increases aggregate
demand.
5. Supply-side economists think that a tax cut increases
aggregate supply by a large amount so that GDP
increases and the price level does not change (or
might even fall).
6. Most economists believe that the increase in aggregate
demand exceeds that in aggregate supply, so GDP
increases and the price level rises, but by less than
would be the case without the increase in aggregate
supply.
B. Fiscal Policy and Economic Growth
1. Fiscal policy also influences economic growth by
changing the incentives to save, invest, and innovate.
These incentives work similarly to those in the labor
market.
2. Fiscal policy can also influence growth and the wellbeing of future generations by crowding out investment
and increasing foreign debt. Figure 26.14 (page
621/275) illustrates these effects.