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ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Fiscal Policy:

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Presentation on theme: "ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Fiscal Policy:"— Presentation transcript:

1 ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Fiscal Policy: Taxes, Spending, and the Federal Budget

2 2 Fiscal Policy: Taxes, Spending, and The Federal Budget Almost every year throughout 1980s, and early 1990s, a best-selling book would be published that predicted economic disaster for United States and world During late 1990s, as federal budget picture improved, these disaster books quietly disappeared Then, in 2002, another flip-flop –Government was again running a deficit, and more deficits were projected till the end of the 2000s and beyond What caused these flip-flops in the government’s budget? –And why should we care?

3 3 Thinking About Spending, Taxes, and the Budget In 1959, federal government’s total outlays were $92 billion –Goods and services, transfer payments, and interest on its debt By 2003 total had grown to $2,140 billion, an increase of more than 2,200% Consider national debt—total amount government owes to the public from past borrowing in years in which it ran a budget deficit –In 1959, national debt was $209 billion By beginning of 2003, it had grown to $2,936 billion –Is this our evidence that debt is crushing economy?

4 4 Thinking About Spending, Taxes, and the Budget From 1959 to 2003 U.S. population grew, labor force grew, and average worker became more productive –Why is that important? Because spending and debt should be viewed in relation to income We automatically recognize this principle when we think about an individual family or business What is true for an individual family is also true for nation –Budget-related figures such as government outlays, tax revenues, or government debt should be considered relative to a nation’s total income—as percentage of GDP In 1959, federal government’s total outlays were 19% of GDP –In 2003, they were about 20%—reflecting a slight upward drift, but far from out of control –Our concerns should be based on, and expressed with, proper perspective

5 5 Spending, Taxes, and the Budget: Some Background Our ultimate goal in this chapter is to understand how fiscal changes have affected, and continue to affect, macroeconomy –Why has national debt decreased in some years, risen slowly in other years, and risen very rapidly in still others? –Although state and local spending also play an important role in the macroeconomy Most significant macroeconomic changes in recent decades have involved federal government

6 6 Government Outlays Federal government’s outlays—total amount spent or disbursed by federal government in all of its activities—can be divided into three categories –Government purchases –Transfer payments –Interest on national debt

7 7 Government Purchases Until 1980s, government purchases of goods and services were largest component of government spending –To understand how these purchases have changed over time, it’s essential to divide them into two categories Military and non-military Federal government uses up only a tiny fraction or our national resources for non-military purposes Strongly contradicts a commonly held notion –Government spending is growing by leaps and bounds because of bloated federal bureaucracies As a percentage of GDP, non-military government purchases have remained very low and stable –Have not contributed to growth in total government outlays What about military purchases? –Here, we come to an even stronger conclusion As a percentage of GDP, military purchases have declined dramatically over past several decades Like non-military purchases, they have not contributed to upward drift in government outlays

8 8 Figure 1: Federal Government Purchases as a Percentage of GDP

9 9 Government Purchases Military purchases were around 10% of GDP in 1959, fell almost continuously to about 3% in late 1990s, and started to rise again in early 2000s Implications are tremendously important for thinking about recent past and future of federal government’s role –Decline in military spending in relation to GDP since early 1960s has made huge amounts of resources available for other purposes –Because military spending has little room to fall further and is likely to rise over next decade, there cannot be any similar freeing up of resources in coming years Resources released from military spending eased many otherwise tough decisions about resources allocation –Likelihood of continued increases in military spending will have the opposite implication Government will presented with difficult budget choices

10 10 Social Security and Other Transfers Transfer programs provide cash and in-kind benefits to people whom federal government designates as needing help Largest category is retirement benefits –Payments made by Social Security system to retired people Second-largest category of transfers—and fastest-growing—occurs in health programs –Social Security system provides health-related benefits to everyone aged 62 and over through Medicare Third and smallest of the three categories of transfers is income security –Programs to help poor families

11 11 Figure 2: Major Federal Transfer Programs, 2001

12 12 Social Security and Other Transfers Have transfer payments been growing as a fraction of GDP? –Yes –All three categories of transfer programs have grown rapidly in recent decades In recent decades, transfers have been the fastest- growing part of the federal government outlays and are currently equal to about 12.5% of GDP Growth in transfers relative to GDP was most rapid in 1970s during Nixon administration Transfers are sensitive to ups and downs of the economy –Transfers as a fraction of GDP rise during recessions Number of needy recipients rises in a recession GDP falls in a recession

13 13 Figure 3: Federal Transfer Payments as a Percentage of GDP

14 14 Figure 4: Federal Government Interest Payments as a Percentage of GDP

15 15 Total Government Outlays Figure 5 shows total outlays in relation to GDP over past several decades Important things to notice in the figure –Fluctuations in government outlays over the period –Upward trend of federal outlays as a percentage of GDP Over past several decades, and until early 1990s, federal government outlays as a percentage of GDP drifted upward –Main causes were increases in transfer payments and increases in interest on national debt that exceeded decreases in military spending –Downward trend in mid and late 1990s From 1992 to 2000, federal government spending as a percentage of GDP fell steadily, although it remained a higher percentage of GDP than in 1959 –Main causes of decline were »Sharp decreases in military spending »More modest decreases in transfer payments relative to GDP during a long expansion

16 16 Figure 5: Total Federal Outlays As A Percentage of GDP

17 17 Total Government Outlays However, Figure 5 also shows the appearance of a likely new trend –In early 2000s, due to a rise in military and domestic security purchases and continued increases in transfer Federal government outlays as a percentage of GDP began rising, and seem likely to continue rising through decade These trends in government outlays have important implications, but they are only half of the story In order to understand their impact on the budget and the macroeconomy, we must look at the other side of the budget –Tax revenue

18 18 The Personal Income Tax Most important source of revenue for federal government –Also most conspicuous and painful Designed to be progressive –Tax those at the higher end of the income scale at higher rates than those at the lower end of the scale –Excuse poorest families from paying any tax at all We can see from Table 2 that income tax is designed to be quite progressive But tax system shown in the table does not reflect ways that people can avoid tax –Many people have deductions far above standard deduction Also, remember that we are looking at federal personal income tax only

19 19 Table 2: The 2002 Personal Income Tax for a Married Couple with Two Children

20 20 The Social Security Tax Applies to wage and salary income only –Put in place in 1936 to finance Social Security system created in that year Because payroll tax applies only to earnings below a certain level, it is regressive Social Security tax is actually largest tax paid by many Americans –Especially those with lower incomes

21 21 Other Federal Taxes Federal government also collects around $300 billion annually from other taxes Corporate profits tax is often criticized by economists because of two important problems –Only applies to corporations –Results in double taxation on the portion of corporate profits that corporations pay to their owners Federal government also taxes consumption of certain products –Such as gasoline, alcohol, tobacco, and air travel Called excise taxes

22 22 Trends in Federal Tax Revenue Federal revenue trended upward from around 18% of GDP in early 1960s to around 20% in late 1990s In early 2000s, federal tax revenues began a projected downward trend due to long-term reductions in tax rates While trends in total federal revenue as a fraction of GDP have been rather mild, its composition has changed dramatically Why have Social Security taxes grown in importance? –Social Security system operates on a pay-as-you-go principle Taxes people who are working now in order to pay benefits to those who worked earlier and are now retired –For past several decades, system benefited from two favorable demographic factors Relatively small number of retirees Large number of taxpayers

23 23 Figure 6: Federal Government Revenue As A Percentage of GDP

24 24 Trends in Federal Tax Revenue But now some demographic trends are working against the system –Improved health is allowing people to spend a larger fraction of their lives in retirement At the same time, baby boomers will begin retiring en masse in late 2000s –Means greater numbers of people drawing benefits –These increased benefits will be funded by a smaller number of working taxpayers As a result of these trends, government has been raising Social Security tax rates –Not just to keep the system solvent, but to go further »Building up reserves for retiring baby boomers

25 25 Trends in Federal Tax Revenue Ultimately, however, keeping social security reserves in a separate account is important for psychological and political reasons –Making retirees and future retirees feel confident that money is being held for them –But focus on keeping trust fund solvent has had a side-effect Caused government to continually raise regressive payroll tax rate over past few decades –Rather than rely on the progressive personal income tax to fund the system

26 26 The Federal Budget and the National Debt Budget Surplus = Tax Revenue – Outlays Budget Deficit = Outlays – Tax Revenue Even though world has changed much since 1980s, reasons for the deficits of early 2000s seem like a repeat of history –A recession –Increased military spending –Sizeable, multi-year tax cut

27 27 Figure 7(a): The Federal Budget Deficit or Surplus as a Percentage of GDP

28 28 Figure 7(b): The Federal Budget Deficit or Surplus as a Percentage of GDP

29 29 The National Debt Need to address some common confusion among three related, but very different, terms –Federal deficit –Federal surplus –National debt Federal deficit and surplus are flow variables –Measure difference between government spending and tax revenue over a given period, usually a year –National debt, by contrast, is a stock variable Measures total amount that federal government owes at a given point in time Relationship between these terms –Each year government runs a deficit, it must borrow funds to finance it, adding to national debt

30 30 The National Debt Can measure national debt as total value of government bonds held by public –Deficits—which add to the public’s holdings of government bonds—add to national debt –Surplus—which decrease the public’s bond holdings— subtract from national debt Since cumulative total of government’s deficits has been greater than its surpluses –National debt has grown over past several decades Rise and fall in national debt also explains another trend –Rise and fall in interest payments the government must make to those who hold government bonds

31 31 Figure 8: Federal Debt as a Percentage of GDP

32 32 How Economic Fluctuations Affect the Federal Budget Economic fluctuations affect both transfer payments and tax revenues –In a recession, because transfers rise and tax revenue falls, federal budget deficit increases (or surplus decreases) An expansion has the opposite effects on federal budget –Because transfers decrease and tax revenue rises, budget deficit decreases (or surplus increases) Because business cycle has systematic effects on spending and revenue, economists find it useful to divide deficit into two components –Cyclical deficit Part of federal budget deficit that varies with business cycle –Structural deficit Part of federal budget deficit that is independent of business cycle Cyclical changes in the budget are not a cause for concern, because they average out to about zero, as output fluctuates above and below potential output –Thus, cyclical deficit should not contribute to a long-run rise in national debt

33 33 How the Budget Affects Economic Fluctuations Budget changes that occur automatically during expansions and recessions have an important impact –Help to make economic fluctuations milder than they would otherwise be Changes in cyclical deficit make multiplier smaller, and thus act as an automatic stabilizer –Many features of federal tax and transfer systems act as automatic stabilizers As economy goes into a recession, these features help to reduce decline in consumption spending –Also cause cyclical deficit to rise As economy goes into an expansion, these features help to reduce rise in consumption spending –Also cause cyclical deficit to fall Immediately raises a question –If automatic changes in budget help to stabilize economy, can government purposely change its spending or tax policy to make economy even more stable?

34 34 Countercyclical Fiscal Policy When government uses fiscal policy to keep economy closer to potential GDP in short- run, it is engaging in countercyclical fiscal policy In 1960s and 1970s, many economists and government officials believed that countercyclical fiscal policy could be an effective tool to counteract business cycle –Today, however, economists tend to be more skeptical Why? –Because counter-cyclical fiscal policy is plagued with several problems

35 35 Timing Problems Takes many months or even longer for most fiscal changes to be enacted –Even if all goes smoothly But in most cases, it will not go smoothly Fed, by contrast, can increase or decrease money supply on very day it decides that change is necessary

36 36 Irreversibility To be effective, countercyclical fiscal policy must be reversible –Many temporary tax changes become permanent as well Public is never happy to see a tax cut reversed Government is often reluctant to reverse a tax hike that has provided additional revenue for government programs Reversing monetary policy, while not painless, is easier to do –Moreover, public and Congress have largely accepted Fed’s role in stabilizing the economy –Expect that interest rate will be adjusted as condition of economy changes

37 37 The Fed’s Reaction Even if government attempted to stabilize economy with fiscal policy, it could usually not do so very effectively –Because Fed would not allow it –Fed views most changes in fiscal policy just as it views other changes in aggregate expenditure As a change to be neutralized –As long as Fed remains free to set its own course, and sees its goal as stabilizing the economy at full employment with low inflation There is generally no opportunity—and no need—for countercyclical fiscal policy

38 38 The Effects of Fiscal Changes in the Long-Run Fiscal changes have important effects on economy over long-run Important conclusions about fiscal policy in classical model –Government’s tax transfer policies can influence rate of labor force participation –Government’s tax policies can directly influence rate of investment spending on new capital and R&D –Government’s budget deficit can influence investment spending as well And, from this chapter, you’ve learned the following –Budget deficits add to national debt But what are consequences of adding to national debt?

39 39 The National Debt On a billboard in midtown Manhattan, a giant clock-like digital display tracks U.S. national debt and how it changes each minute National debt clock was one of several public relations campaigns that spread fear among American public Economists do have concerns about national debt –But they are very different from concerns suggested by national debt clock or other similar gimmicks

40 40 Mythical Concerns About the National Debt What bothers many people about a growing national debt is belief that one day we will have to pay it all back –But although we might choose to repay national debt, we do not have to Ever –How could a government keep borrowing funds without ever paying them back? Surely, no business could behave that way But actually, many successful business do behave that way, and continue to prosper Of course, this does not mean that any size debt would be prudent –Debt and interest payments have meaning only in relation to income All of these observations apply to federal government as well –As long as nation’s total income is rising, government can safely take on more debt

41 41 Mythical Concerns About the National Debt Federal government could pay back national debt –By running budget surpluses for many years How large could annual deficits be without making national debt a looming danger? As long as total national income grows at least as fast as interest payments on debt –Ratio of interest payments to income will not grow –In that case, we could continue to pay interest without increasing average tax rate on U.S. citizens

42 42 A National Debt That Is Growing Too Rapidly Important minimal guideline for responsible government is that debt should grow no faster than nominal GDP Important implications –To prevent a long-term disaster after too-rapid growth in the debt, we do not have to run budget surpluses –Even a temporary violation of the guideline is costly How can tax burden be brought back down after a temporary violation of the guideline? –Raise growth rate of nominal GDP above growth rate of the debt for some time –Lower growth rate of debt below growth rate of nominal GDP for some time

43 43 A National Debt That Is Growing Too Rapidly But these solutions are costly to society –Consider Raising growth rate of nominal GDP Slowing down growth rate of debt below growth rate of nominal GDP A debt that rises too fast—faster than nominal GDP—for some period of time will impose an opportunity cost in the future –Cost will be either a permanently higher tax burden, a period of inflation, or a temporary period of reduced government outlays or higher taxes relative to GDP This is not just theoretical, as U.S. experience during 1970s and 1980s demonstrates –Fortunately, 1990s was a period of prolonged expansion and reduced military purchases Opportunity cost of lower deficits was not as painful as it might otherwise have been

44 44 A Debt Approaching the National Credit Limit If debt were to rise too rapidly relative to GDP, for too long –There is a theoretical danger of reaching nation’s credit limit Amount of debt that would make lenders worry about government’s ability to continue paying interest While this is a theoretically sound danger of a rapidly-rising debt –Doubtful United States has been anywhere near that limit during recent decades

45 45 Failing to Account for Future Obligations Many students reading this book are getting financial help from parents to pay costs of college –Planning for this obligation may have begun very early—perhaps even before you knew what college was Federal government is in an analogous situation –It has effectively promised to provide Medicare and social security payments to millions of people at some time in the future Of course, trying to project total federal revenues and outlays over the next 75 years, 50 years, or even 15 years would be guesswork at best This uncertainty over future projections has led to divergent views about policy These divergent views formed part of background for controversy over Bush tax cuts

46 46 Using the Theory: The Bush Tax Cuts of 2001 and 2003 In 2001, Bush administration cut taxes over ten years by $1.35 trillion, and in 2003, by another $350 billion Much of debate over tax reductions had to do with distribution –Whether cuts were apportioned fairly among different income groups –But they also raised two important macroeconomic issues that we’ve discussed in this chapter

47 47 The Short Run: Countercyclical Fiscal Policy? Tax cuts of 2001 and 2003 seem like perfect examples of well-timed countercyclical fiscal policy –Does this show that countercyclical fiscal policy works? Not really, because a closer look suggests that neither tax cut was really designed for that purpose –Tax cut of June 2001 had actually been proposed more than 18 months earlier by presidential candidate Bush as a long-run policy measure, to promote growth in potential output –Fact that tax reduction was enacted during a recession was a stroke of luck—not a example of well-timed short-run fiscal policy Remember that countercyclical fiscal policy requires that changes in taxes be reversible when economic conditions change

48 48 The Short Run: Countercyclical Fiscal Policy? As so often happens in macroeconomic debates, however, politics took over In between these two cuts, however, Bush administration proposed a smaller, $60 billion tax cut –If there was ever an opportunity to showcase effectiveness of countercyclical fiscal policy, this was it –But tax bill was debated for a full six months in House and Senate, and was not signed by President until March, 2002

49 49 The Long Run: The Tax Cuts and the National Debt Table 3 shows two different projections of budget deficits and national debt Judging by OMB’s numbers, it appears that the administration’s fiscal policy is an example of a temporary violation of the guideline for responsible government –Debt is rising faster than GDP through 2006, and then stabilizing and descending What do these numbers tell us? –Certainly not a debt disaster –But a fiscal policy with future costs Where does this rise in debt come from? –Some of the early rise comes from cyclical deficits –But continued deficits in 2006 and beyond—when the economy is assumed to have recovered—are mostly structural deficits

50 50 Table 3: Projected Budget Deficits and the Rising National Debt

51 51 The Long Run: The Tax Cuts and the National Debt Look at lower half of Table 3 –Shows numbers put out by Democratic Caucus of House Budget Committee in a press release, within days of OMB documents release –Shows a more sharply rising deficit, and what looks like a long-run violation of guideline for responsible government –Note that Democratic Caucus projects 10 years forward instead of five –But that only accounts for part of dramatic difference in the fiscal story each side tells What accounts for the rest?

52 52 Figure 9: Countercyclical Fiscal Policy

53 53 The Long Run: The Tax Cuts and The National Debt The answer is –Assumptions behind the numbers Using Democratic numbers, virtually all of the rise in the debt can be attributed to tax cuts of some form –Either original cuts in 2001 and 2003, –Or expected extensions and further reductions Administration has discussed Based on either set of numbers, we are entering a period of rising debt that will entail the kinds of future costs we’ve discussed in the chapter Ultimately, our conclusions about any economic policy must compare costs with benefits

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