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Public Finance: Taxes and Fiscal Policy

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1 Public Finance: Taxes and Fiscal Policy
Fundamentals of Finance – Lecture 10

2 Outline Income Taxes Taxes on Wealth and Property Fiscal Policy
Personal Corporate Consumption and Sales Taxes Taxes on Wealth and Property Fiscal Policy The Keynesian View The New Classical View Fiscal Policy Changes and Problems of Timing Supply-Side Effects of Fiscal Policy

3 1. Income tax a) Personal tax

4 Comprehensive Income: The Haig-Simons Definition
It is “the exercise of control over the use of society’s scarce resources.” Algebraically it is defined as I = C + NW Two preliminary steps are necessary before any comprehensive definition of income can be developed. First, the taxpaying unit must be selected. In the case of a personal income tax, that unit must be the individual. All individuals who earn income, regardless of age or the amount of income earned, will be subject to the tax. No separate tax on business income is necessary. All businesses are owned by individuals. Business income, in one form or another (profits, dividends, retained earnings), accrues to the person(s) who own the businesses. In the case of corporate income, a comprehensive personal income tax would require that all income of the corporation be allocated to shareholders in proportion to their ownership of shares. The second step is to define the time period relevant for measuring personal income. The concept of income is meaningless unless a time period is specified. Income is a flow over time and will vary in amount with the time interval chosen. In an economic sense, income is usually viewed as a measure of a person’s power to purchase goods and services in a given year. As defined by Henry Simons, income is an indicator of “the exercise of control over the use of society’s scarce resources. Income can be spent, thereby converting purchasing power into consumption, or it can be stored for future use. Income can be measured according to its sources or its uses. Sources of income, calculated from the beginning to the end of the accounting period, are earnings from the sale of productive services; transfers from either government or individuals; and increases in the value of assets owned by the individual. Uses of income include consumption, or purchase, of goods and services; taxes; donations; and saving. Increased holdings of assets over liabilities constitute saving. Positive saving in a given year stores income for future consumption. Saving represents an increase in a person’s net worth. Net worth is the value of a person’s assets held at any point in time less the value of a person’s liabilities, or debts. A person’s net worth at any point in time can be positive or negative. In a given year, an individual might save negatively by borrowing funds or by liquidating some assets into cash and spending the cash on consumption items. Also, in a given year, the dollar value of income received from sources must equal the dollar value of all uses of income. Where I = Income C = Consumption NW = The Change in Net Worth

5 Implications of the Haig-Simons Definition
If a person borrows to consume, there is no increase in income because the change in net worth is negative. If a person sells an asset so as to consume, there is no increase in income.

6 Capital Gains Capital gains are the increased value of assets that a person holds. If a person owns a stock that has gone up in value, their net worth increases and therefore they have an increase in income by this definition. This is true whether or not they actually sell the asset and see the money in their bank accounts.

7 Realized and Unrealized Capital Gains
Realized Capital Gains are those gains that a person has received by selling an asset.  Unrealized Capital Gains are those gains that a person has not yet received by selling an asset but exist only on paper as the market price of the asset they hold has increased.

8 An Income Statement Sources of Funds:
Earnings from Sale of Productive Services Transfer Payments Received Capital Gains (or Losses)  Uses of Funds: Consumption Taxes Donations Gifts Saving (Increases in Net Worth)  Sources = Uses So Earnings + Transfer Payments + Net Capital Gains = Consumption + Taxes + Donations + Gifts + Saving

9 Modifications to the Income Definition
The cost of acquiring income needs to be accounted for in the definition. Earnings + Transfer Payments + Net Capital Gains – Cost of Acquiring Income = Consumption + Taxes + Donations + Gifts + Saving – Cost of Acquiring Income

10 Problems with Measuring Income using the Haig-Simons Definition
How do you measure unrealized capital gains on an asset that is not regularly traded? Is the cost of an automobile used to drive to and from work a “cost of acquiring income?” Are child care expenses? Union Dues? Education expenses? How do you distinguish what part of an expense is a cost of acquiring income and what part is merely consumption? A means of measuring income, either from the sources side or the uses side, must be developed before any income tax can be implemented. Most systems of accounting use the sources side as the base for measurement. The Haig- Simons definition of income would require that both realized and unrealized capital gains be included in income; a mechanism would have to be developed to measure increments (and decrements) in the value of all capital assets held by individuals as these gains or losses accrue. Whatever system might be developed also has to adjust these gains for inflation so that only real increases in the potential to consume would be included in income. Although measurement of unrealized gains might be relatively easy for assets that are traded frequently in secondary markets, such as stocks and bonds, administrative problems would make it difficult to measure such gains for all types of assets. For instance, devising an equitable system that could accurately measure annual gains and losses on such assets as real estate, antiques, jewelry, and livestock is probably impossible. Another set of problems stems from adequately defining and delineating costs of earning income. Such expenses are analogous to the costs of running a business and might include such items as tools, work clothes, union dues, child care expense, and such legitimate travel expense as commuting costs to and from work. In other words, all those expenditures that are made neither for consumption nor for adding to net worth would be deductible, as expenses, from income. Some tools that an individual uses in work might also be used for personal purposes and would be considered consumption. The acquisition of skills in training programs or in continued education adds to the individual’s human capital. Thus, expenditures for such activities might be legitimately deducted from income insofar as they will result in higher earnings that will be subject to taxation. However, education that produces human capital for home use is not legitimately deductible if the increased consumption enjoyment stemming from taking crafts courses and various “how-to-do-it ” courses escapes taxation. Many arbitrary judgments would have to be made to decide which expenses are legitimate costs of earning income and which should be considered consumption or increases in net worth. One common method of avoiding these problems is to allow all taxpayers to take a lump- sum deduction designed to cover basic expenses involved in commuting to work, buying work clothing, and so on. As previously indicated, a comprehensive income tax would eliminate the need for a separate tax on corporate business income. In individual proprietorships and partnerships in the United States, business income is already declared as part of the owner’s personal income. A comprehensive income tax would attribute all corporate income to shareholders in proportion to their ownership of stock in the corporation, thereby eliminating the need for a separate corporate income tax.

11 1. Income tax b) Corporate tax

12 Forms of Business Sole Proprietorships Partnerships Corporations
Corporations are granted the legal status of people. This means that they can own property and borrow money If you were to operate your own business, the income that you would earn from its operations would be subject to taxation. As the sole owner of the business, you would be required to file a special part of your personal income tax. After deduction of all the costs of operating your business, including the cost of materials, use of capital, and labor you hire, you would include the net profit as part of your personal income. The tax you paid on your business income in Bulgaria is 15 % after all your taxable income had been computed. The income of sole proprietorships and partnerships is treated as personal income to the owners of businesses. A corporation is a business that is legally established under state laws that grant it an identity separate from that of its owners. The law looks at the corporation as if it were a person! The corporation is a “legal fiction” that is granted the right to engage in litigation, to own property in its own name, and to incur debts. The corporation is treated as a person from the point of view of taxation and the profits of the corporation are subject to a corporate income tax. The owners of a corporation are its shareholders, who acquire transferable stock in the corporation. The portion of their ownership can be measured by their relative share of the value of outstanding stock. Many argue that separate taxation of corporations obscures the fact that the tax ultimately must be borne by the corporation’s shareholders, by other investors, by consumers, or by workers. The ultimate incidence of the corporate income tax among these groups depends on the impact of the tax on the prices of goods and services, the return to investment, and wages. The separate taxation of corporate income is a subject of controversy. In the modern global economy, taxation of corporations also can influence the location of multinational business organizations. If one nation taxes corporations at a higher rate than other nations, it might find that more corporations choose to locate their operations in foreign nations.

13 Corporate Taxes Corporations are subject to a corporate income tax;
Since the corporation is not really a person, the people who bear the burden of this tax depend on the shifting of the tax; The tax could be shifted backwards to employees, shifted forward to consumers or borne by the shareholders.

14 The Tax Base: Measuring Business Income
Using the comprehensive definition of income, business income is receipts + net capital gains income – labor, interest, material, and other business costs. Only realized capital gains are included in net taxable income for corporations. Annual business income is measured by subtracting all business costs from business receipts over a period of one year. To calculate business income, we would first add up the receipts the business takes in from sale of its products or services. Then we would add net capital gains on all business assets held during the year to business income. After gross income was calculated, we would deduct the costs of operating the business during the year. These costs would include labor costs, interest payments, payments for materials and services purchased from other firms, and a measure of the cost of capital equipment used during the year. After deducting all business costs, we would have a measure of the profit of the business—its net taxable income. As with the measurement of personal income, some discrepancies exist between the way corporate income is measured in practice and the comprehensive measure of income. From an economic point of view, both realized and unrealized capital gains should be included in the measure of the business’s gross income. However, in Bulgaria, like in most countries, when measuring business income, only realized capital gains are included in business income. Net realized capital gains (capital gains less an allowable portion of capital losses) are included in corporate income.

15 Taxation of Owner-Supplied Inputs
In a small business setting, the owner works for him or herself. The profit from the business is what this owner is “paid.” Some of this is normal profit, some economic profit. When there is a corporation there is no owner-supplied input so all profit, normal and economic, is taxed. Another problem is the treatment of owner-supplied inputs. For example, in the case of a sole proprietorship operated by its owner, part of the cost of operation is the opportunity cost of the owner–operator’s labor. Because the labor of the owner is not hired in the marketplace, neither payment for labor services nor deduction for that labor cost is ever recorded on the business’s books. However, the owner–operator’s labor is part of the opportunity cost of running the business, and it should be deducted from gross income. The opportunity cost of this owner-supplied service is not deductible in practice when computing business income for taxable purposes. This implies that business income as measured, in practice, includes both the normal profit, which is the opportunity cost of owner-supplied inputs, and the economic profit, which is the surplus of revenues over the opportunity cost of all inputs used during the year.

16 Corporate Profits and Where They Go
Corporate Profits = Corporate Taxes + Retained Earnings + Dividends Retained Earnings are the portion of after-tax corporate profits that a company keeps to invest in the business. Dividends are the portion of after-tax corporate profits that are distributed to households.

17 Economic Depreciation
Economic Depreciation is the amount that an asset devalues over time. When a business buys an expensive capital asset, it cannot deduct from corporate profits the entirety of the value of the asset. Because the asset will be productive for a substantial period of time, companies can only deduct a portion of the value of the asset. Some of the inputs purchased by a business, such as fuel, are used up in the process of production within a short period. However, capital inputs, such as equipment and structures, are long-lived. Vehicles can last 4 to 10 years before they need to be replaced, and structures can last for 50 years and longer. Because capital inputs are seldom consumed or used up completely in the year in which they are purchased, accountants usually distribute their purchase prices over a number of years by including a measure of the depreciation of the capital, rather than its total purchase price, in the annual costs of operating the business. Problems occur in defining the tax base treatment of the replacement cost of capital through depreciation. Economic depreciation measures the decrease in the market value of the durable physical capital used by firms in the productive process as that capital is “used up.” Capital equipment is used up in the sense that it wears out and becomes obsolete over time as technology improves. Depreciation is sometimes referred to as a capital consumption allowance. Its inclusion in cost provides a means for the firm to accumulate a fund so as to recover its capital cost and replace such assets as machines and buildings when they wear out or become obsolete. Ideally, the rate at which an asset is depreciated for tax purposes should coincide with the actual useful economic life of the asset. In fact, however, depreciation rules are arbitrary, and the useful lives of assets as defined by Internal Revenue Service guidelines do not always coincide with their actual useful economic lives. This is of importance in defining the tax base and taxes due from the corporation, because the rate at which the firm is allowed to recover its initial capital cost affects the amount of taxes paid.

18 Accelerated Depreciation
Accelerated depreciation allows businesses to deduct the loss in the value of an asset before it occurs. The ultimate in accelerated depreciation is the allowance for expensing an asset in the year it is purchased. Typically assets are allowed to be depreciated on a straight-line basis, which means in equal increments for the life of an asset. More rapid depreciation allowances give corporations a larger deduction in computing taxable income in early years of the asset’s use. The consequent reduction in tax liability due to faster depreciation allows the corporation to earn more interest income than otherwise would be the case. Accelerated depreciation allows a firm to deduct more than the actual economic depreciation from its income each year. In effect, accelerated depreciation allows a firm to recover the costs of capital equipment more quickly than the equipment is actually used up. The benefit of accelerated depreciation for tax purposes can be substantial to the corporation. For example, suppose a corporation acquires a machine that has a useful economic life of 10 years. The purchase price of the machine is $100,000. At the extreme, the firm could be allowed to depreciate the machine fully in the year of its acquisition; that is, it could deduct the full purchase price of the machine from its taxable income in the year that the machine is acquired. Deduction of the full purchase price of an asset in the year of its acquisition is called expensing a capital asset.

19 Double Taxation of Corporate Income
Corporate Income is considered to be double-taxed because it faces taxes on the same income twice. The Corporation must pay taxes on the profits then the shareholders must pay taxes on the amount they receive in either dividends or capital gains. Under a comprehensive income tax this would not happen. Corporate profits, either retained or paid in dividends, would enter individual income tax structures according to the percentage of the corporation owned by each shareholder. The current policy of separate taxation of total corporate income and of the portion of income paid out as dividends to individuals subjects a substantial portion of corporate income to double-taxation. The reason for this is that all corporate income is subject to taxation when it is earned, and that portion of profits paid out as dividends is then subject to taxation under the personal income tax, as part of the tax liability for shareholders who receive dividend income. Such double-taxation of corporate income paid out as dividends serves to increase the effective rate of taxation on corporate investment. If the corporate income tax were to be integrated into the personal income tax, as has been suggested by those advocating a comprehensive income tax, no such double-taxation would exist. Under comprehensive income taxation, corporate profits would be distributed to shareholders on a pro rata basis according to their share of ownership in the corporation. This reduces the rate of taxation of corporate profits due to the elimination of double-taxation of corporate income paid out as dividends. Owners of corporate stock would experience windfall gains in terms of an increase in the value of their corporate stock, but only if the value of previous excess taxation had been capitalized into reduced stock prices in the past. However, these gains, when realized, would be subject to taxation under the provisions of the personal income tax.

20 Arguments in Favor of Double Taxing Corporate Income
Unrealized Capital Gains and the Stepped-Up Basis: A major source of unrealized capital gains for individuals is corporate stocks. If the business profit were not taxed at the corporate level, it may never be taxed. Compensation for Bankruptcy Protection: Individuals are not liable for the bankruptcy of assets they hold in corporations whereas they are in cases of proprietorships and partnerships.

21 The Consequence of Double Taxation: A Bias Toward Debt Finance
A corporation can raise money by borrowing or it can raise money by selling stock. The corporation can deduct from its profits the amount it pays in interest to its bondholders. It cannot deduct the dividends it pays to its stockholders. This encourages debt finance over equity finance.

22 Demonstrating the Bias toward Debt Finance
Assumptions: 10% interest; 34 % tax rate Item All-Equity 50% Debt – 50% Equity Balance Sheet Total Assets $1,000,000 Debt $500,000 Shareholder’s Equity Income Statement Operating Income $150,000 Interest Expense $50,000 Taxable Income $100,000 Income Tax $51,000 $34,000 Income after Corporate Tax $99,000 $66,000 Return on Equity 9.9% 13.2% Conclusion: The taxation of corporate profits combined with the deductibility of interest raises the after-tax return on equity to firms in greater debt thereby motivating firms to increase their debt burdens to an inefficiently high level.

23 2. Consumption and sales taxes

24 Consumption as a Tax Base
Consumption can be an alternative to income as a measure of ability to pay. Comprehensive consumption: Income-Savings Note that capital gains would not be taxed if it were not spent. Consumption, or current expenditure, is an alternative to income as a tax base. The heavy reliance on income taxes at the federal level in the United States, however, reflects a commonly held notion that income is a superior index of the ability to pay. This notion is also reflected in economic analysis inasmuch as taxes are evaluated in terms of their effects on the distribution of income. Incidence is almost always calculated with respect to an income base. In recent years, economists’ renewed interest in the consumption base reflects their persistent belief that consumption is, in fact, a good (superior, some argue) index of the ability to pay. Also, concern is increasing about relatively high efficiency losses associated with taxation of income from saving and investment. Consumption taxes are more favorable to saving and investment incentives than income taxes. A general tax on consumption is equivalent to an income tax that allows savings to be excluded from the tax base. Annual comprehensive consumption is annual comprehensive income minus annual savings. This chapter discusses the feasibility of a general tax on comprehensive consumption. The advantages and disadvantages of such a tax compared with a comprehensive income tax will be analyzed in next slides.

25 Comparing a Tax on Income to a Tax on Consumption
Assumptions Two equally situated persons with no physical capital Wages = $30,000 per year Interest rates = 10% Flat rate tax for either consumption or income of 20%. Two earning periods. They have equal ability to pay taxes over their lifetime so they should pay equal taxes over their lifetime.

26 Comparing a Tax on Income to a Tax on Consumption: Step 1 An Income Tax
IA = IB = $30,000 SA = 0 SB = $5,000 TA = $6,000 + $6,000/(1+.1) = $6,000 + $5,455 = $11,455 TB = $6,000 + $6,100/(1+.1)/(1+.1) = $6,000 + $5,545 = $11,545

27 Comparing a Tax on Income to a Tax on Consumption: Step 2 A Consumption Tax for the Non-Saver
Income = Consumption + Consumption Tax +Savings First and Second Year IA = CA + TA + SA $30,000 = CA + .2CA + 0 CA = $25,000 TA = $5,000 SA = 0 Present Value of All Taxes TA = $5,000 + $5,000/(1+.1) = $5,000 + $4, = $9,545.45

28 Comparing a Tax on Income to a Tax on Consumption: Step 2 B Consumption Tax for the Saver
First Year IB = CB + TB + SB $30,000 = CB +.2CB + $5,000 CA = $20,583.33 TA = $4,166.66 SA = $5,000 Second Year IB + Proceeds from Saving = CB + TB $35,500 = CB + .2CB CA = $29,583.33 TA = $5,916.67 Present Value of All Taxes TB = $4, $5,916.67/(1+.1) = $4, $5, = $9,545.45

29 Comparing a Tax on Income to a Tax on Consumption
Under an Income tax, savers pay more in tax than non-savers. Under a consumption tax, they pay the same present value of taxes.

30 Impact of a Sales Tax on the Efficiency in Labor Markets
A substitution of a consumption tax for an income tax (with equal yields) would require a higher tax rate because of savings. The net efficiency change depends on whether the gain in the investment market is greater than the loss in the labor market. Estimates suggest such a change would have a positive impact on GDP.

31 A Sales Tax A retail sales tax is typically a fixed percentage on the dollar value of retail purchases. Sales taxes are a major source of tax revenue for state and local governments. Some state rates are as high as 7% with local governments adding an additional 3% on top of that. Often food and medicine are exempt.

32 An Excise Tax An excise tax is a selective tax on particular goods.
In Bulgaria excise taxes exist on alcohol, tobacco and tobacco products, and energy resources (petrol, natural gas, oil, electricity).

33 The Incidence of Sales and Excise Taxes
Generally, sales taxes are regressive when food and medicine are not exempt. A national sales tax would be borne by labor income and would lack the progressive rate structure of the personal income tax.

34 Turnover Taxes Turnover taxes are multistage taxes that are levied at some fixed rate on transactions at all levels of production. The effective rate of tax depends on the number of times the good is sold during the production process. This creates a significant bias toward vertical integration (where all production stays within the same firm).

35 A Value-Added Tax A value-added tax (VAT) is a consumption-based tax levied at each stage of production. Value Added = Total Transactions – Intermediate Transactions = Final Sales = GDP = Wages + Interest + profits + Rents + Depreciation Tax Liability = Tax on Payable Sales – Tax Paid on Intermediate Purchases = t(sales) – t(purchases) = t(sales – purchases) = t(value added)

36 The VAT in Europe The VAT accounts for about 20% of EU member nation revenue. The average rates within the EU are between 15 and 20%. Different rates apply to different types of goods with luxury items facing the highest rate and necessities facing the lowest. The tax applies to services as well as goods. Economists find the VAT a good alternative to an income tax because it does less to discourage savings and investment.

37 3. Property Taxes

38 A Comprehensive Wealth Tax Base
Real Property is property such as land and the structures on the land. Intangible Property is wealth that is held as paper or financial assets.  Personal Property is wealth that is held in the form of cars, furniture, clothing, jewelry, etc.

39 Measuring Wealth Market value can be used to establish the value of most real property and intangible property but personal property has no acceptable resale market. Serious inequities can arise from mismeasurement of wealth and serious shifting can take place when one form of wealth is taxed while another is not.

40 Assessment of Property Value
For the property tax, the assessed value of a home and the land upon which it sits is quite subjective. Real-estate markets exists for many homes but not others.

41 4. Fiscal Policy

42 Budget Deficits and Surpluses
Budget deficit: Present when total government spending exceeds total revenue from all sources. When the money supply is constant, deficits must be covered with borrowing. Governments borrow by issuing bonds. Budget surplus: Present when total government spending is greater than total revenue. Surpluses reduce the magnitude of the government’s outstanding debt.

43 Budget Deficits and Surpluses
Changes in the size of the deficit or surplus are often used to gauge whether fiscal policy is stimulating or restraining demand. Changes in the size of the budget deficit or surplus may arise from either: A change in the state of the economy, or, A change in discretionary fiscal policy. The budget is the primary tool of fiscal policy. Discretionary changes in fiscal policy: Deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.

44 4. Fiscal Policy a) The Keynesian view

45 The Keynesian View of Fiscal Policy
Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in aggregate demand. Following the Great Depression, Keynesians challenged the view that governments should always balance their budget. Rather than balancing their budget annually, Keynesians argue that counter-cyclical policy should be used to offset fluctuations in aggregate demand. This implies that the government should plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.

46 Keynesian Policy to Combat Recession
When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy, by: increasing the government’s purchases of goods & services, and/or, cutting taxes.

47 Expansionary Fiscal Policy
Price Level SRAS1 LRAS AD2 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. SRAS2 P2 E2 P1 e1 Expansionary fiscal policy stimulates demand and directs the economy to full-employment P3 E3 AD1 Goods & Services (real GDP) Y1 YF At e1 (Y1), the economy is below its potential capacity YF . There are 2 routes to long-run full-employment equilibrium: Wait for lower wages and resource prices to reduce costs, increase supply to SRAS2 and restore equilibrium to E3, at YF. Alternatively, expansionary fiscal policy could stimulate AD (shift to AD2) and guide the economy back to E2, at YF .

48 Keynesian Policy To Combat Inflation
When inflation is a potential problem, Keynesian analysis suggests a shift toward a more restrictive fiscal policy by: reducing government spending, and/or, raising taxes.

49 Restrictive Fiscal Policy
Price Level SRAS2 LRAS SRAS1 AD2 P3 E3 P1 e1 Restrictive fiscal policy restrains demand and helps control inflation. P2 E2 AD1 Goods & Services (real GDP) YF Y1 Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential YF. If maintained, the strong demand will lead to the long-run equilibrium E3 at a higher price level (SRAS shifts to SRAS2). Restrictive fiscal policy could reduce demand to AD2 (or keep AD from shifting to AD1 initially) and lead to equilibrium E2.

50 The Crowding-out Effect
The Crowding-out effect – indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy. The implications of the crowding-out analysis are symmetrical. Restrictive fiscal policy will reduce real interest rates and "crowd in" private spending. Crowding-out effect in an open economy: Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

51 Crowding-Out in an Open Economy
Decline in private investment Increase in budget deficit Higher real interest rates Inflow of financial capital from abroad Appreciation of the dollar Decline in net exports An increase in government borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. This retards private investment and Aggregate Demand. In an open economy, high interest rates attract foreign capital. As foreigners buy more domestic currency to buy domestic bonds and other financial assets, the domestic currency appreciates. The appreciation of the domestic currency causes net exports to fall. Thus, the larger deficits and higher interest rates trigger reductions in both private investment and net exports, which limit the expansionary impact of a budget deficit.

52 4. Fiscal Policy b) The New Classical view

53 The New Classical View of Fiscal Policy
The New Classical view stresses that: debt financing merely substitutes higher future taxes for lower current taxes, and thus, budget deficits affect the timing of taxes, but not their magnitude. New Classical economists argue that when debt is substituted for taxes: people save the increased income so they will be able to pay the higher future taxes, thus, the budget deficit does not stimulate aggregate demand.

54 The New Classical View of Fiscal Policy
Similarly, New Classical economists believe that the real interest rate is unaffected by deficits as people save more in order to pay the higher future taxes. Further, they believe fiscal policy is completely impotent – that it does not affect output, employment, or real interest rates.

55 Expansionary Fiscal Policy
Price Level AD2 SRAS1 P1 AD1 Goods & Services (real GDP) Y1 New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes. If households did not anticipate the higher future taxes, aggregate demand would increase (from AD1 to AD2). However, when households fully anticipate the future taxes and save for them, demand remains unchanged at AD1.

56 Expansionary Fiscal Policy
Loanable Funds Market Real interest rate D2 S1 S2 e1 e2 Here, fiscal policy exerts no effect on the interest rate, real GDP, or unemployment. r1 D1 Quantity of loanable funds Q1 Q2 To finance the budget deficit, the government borrows from the loanable funds market, increasing the demand (to D2). Under the new classical view, people save to pay expected higher future taxes (raising the supply of loanable funds to S2.) This permits the government to borrow the funds to finance the deficit without pushing up the interest rate.

57 4. Fiscal Policy c) Changes and problems of timing

58 Problems with Proper Timing
There are three major reasons why it is difficult to time fiscal policy changes in a manner that produces stability: It takes time to institute a legislative change. There is a time lag between when a change is instituted & when it exerts significant impact. These time lags imply that sound policy requires knowledge of economic conditions 9 to 18 months in the future. But our ability to forecast future conditions is limited. Discretionary fiscal policy is like a two-edged sword; it can both harm and help: If timed correctly, it may reduce economic instability. If timed incorrectly, however, it may increase economic instability.

59 Timing of Fiscal Policy is Difficult
LRAS Price Level SRAS1 AD1 P0 E0 P1 e1 AD0 Goods & Services (real GDP) Y1 Y0 Consider a market at long-run equilibrium E0 where only the natural rate of unemployment is present. An investment slump and business pessimism result in an unanticipated decline in AD (to AD1). Output falls (to Y1) and unemployment increases.

60 Timing of Fiscal Policy is Difficult
LRAS Price Level SRAS1 Suppose that shifts in AD are difficult to forecast. P0 E0 P1 e1 AD0 AD1 Goods & Services (real GDP) Y1 Y0 After a time, policymakers consider and implement expansionary fiscal policy seeking to shift AD1 back to AD0. But it will take time to institute changes in taxes and expenditures. Political forces will slow this process.

61 Timing of Fiscal Policy is Difficult
LRAS Price Level AD2 SRAS1 P0 E0 P1 e1 AD0 AD1 Goods & Services (real GDP) Y1 Y0 By the time a more expansionary fiscal policy is instituted and begins to exert its primary effect, private investment may have recovered and decision makers may therefore be increasingly optimistic about the future. Hence, the more expansionary fiscal policy may over-shift AD to AD2.

62 Timing of Fiscal Policy is Difficult
SRAS2 LRAS Price Level SRAS1 P3 E3 P2 e2 P0 E0 P1 e1 AD2 AD0 AD1 Goods & Services (real GDP) Y1 Y0 Y2 The price level in the economy rises (from P1 to P2) as the economy is now overheating. Thus, incorrect timing leads to inflation. Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS2 (driving the price level up to P3).

63 Timing of Fiscal Policy is Difficult
LRAS Price Level AD2 SRAS1 P2 e2 P0 E0 AD0 Goods & Services (real GDP) Y0 Y2 Alternatively, suppose an investment boom disrupts the initial equilibrium shifting AD out to AD2, and prices upward to P2. Policymakers consider and eventually implement an increase in taxes and a cut in government expenditures.

64 Timing of Fiscal Policy is Difficult
LRAS Price Level SRAS1 AD1 Suppose that shifts in AD are difficult to forecast. P2 e2 P0 E0 P1 e1 AD2 AD0 Goods & Services (real GDP) Y1 Y0 Y2 By the time the more restrictive fiscal policy takes affect, investment may have returned to its normal rate (shifting AD2 back to AD0). In this case, the incorrect timing of the shift to the more restrictive fiscal policy to deal with potential inflation throws the economy into a recession (by over shifting AD to AD1).

65 Why Timing of Fiscal Policy Changes Are Difficult: A Summary
Because fiscal policy does not work instantaneously, and since dynamic forces are constantly influencing private demand, proper timing of fiscal policy is not an easy task. Further, political incentives also influence fiscal policy. Public choice analysis indicates that legislators are delighted to spend money on programs that directly benefit their own constituents but are reluctant to raise taxes because they impose a visible cost on voters. There is a political bias towards spending and budget deficits. Predictably, deficits will be far more common than surpluses. Incorrectly timed policy changes may, them-selves, be a source of economic instability.

66 Automatic Stabilizers
Automatic Stabilizers: Without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action. Examples of automatic stabilizers: Unemployment compensation Corporate profit tax A progressive income tax

67 4. Fiscal Policy d) Supply-side Effects of Fiscal policy

68 Supply-side Effects of Fiscal Policy
From a supply-side viewpoint, the marginal tax rate is of crucial importance: A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less heavily taxed. High marginal tax rates will tend to retard total output because they will: discourage work effort and reduce the productive efficiency of labor, adversely affect the rate of capital formation and the efficiency of its use, and, encourage individuals to substitute less desired tax-deductible goods for more desired non-deductible goods.

69 Supply-side Effects of Fiscal Policy
So, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance. Impact of supply-side effects: Usually take place over a lengthy time period. There is some evidence that countries with high taxes grow more slowly—France and Germany versus United Kingdom. While the significance of supply-side effects are controversial, there is evidence they are important for taxpayers facing extremely high tax rates – say rates of 40 percent or above.

70 Supply Side Economics and Tax Rates
LRAS1 LRAS2 Price Level SRAS1 AD2 SRAS2 With time, lower tax rates promote more rapid growth (shifting LRAS and SRAS out to LRAS2 and SRAS2). E1 P0 E2 AD1 Goods & Services (real GDP) YF1 YF2 What are the supply-side effects of a cut in marginal tax rates? Lower marginal tax rates increase the incentive to earn and use resources efficiently. AD1 shifts out to AD2, and SRAS & LRAS shift to the right. If the tax cuts are financed by budget deficits, AD may expand by more than supply, bringing an increase in the price level.

71 Have Supply-siders Found
a Way to Soak the Rich? Since 1986 the top marginal personal income tax rate in the United States has been less than 40% compared to 70% or more prior to that time. Nonetheless, the top one-half percent of earners have paid more than 25% of the personal income tax every year since 1997. This is well above the 14% to 19% collected from these taxpayers in the 1960s and 1970s when much higher marginal personal income tax rates were imposed on the rich.


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