13 FISCAL POLICY Government Spending and Tax Policy Part 2

Supply-Side Effects of Fiscal Policy Taxes and the Incentive to Save and Invest Premise: A tax on interest income lowers the quantity of saving and investment and slows the growth rate of real GDP. The interest rate that influences saving and investment is the real after-tax interest rate. The real after-tax interest rate subtracts the income tax paid on interest income. If nominal interest rate is 5% and tax rate (t) is 25%, the after tax nominal interest rate is: 5% - (.25 x 5%) = 3.75%. If inflation is 2%, subtract inflation to get the real after-tax interest rate: 3.75% - 2.00% = 1.75% Classroom activity Check out Economics in the News: Taxes and the Global Location of Business

Supply-Side Effects of Fiscal Policy An income tax on interest and capital income reduces the supply of loanable funds and raises interest rates and discourages investment. A tax wedge is driven between the real interest rate and the real after-tax interest rate. Saving and investment fall from $2 trillion to $1.8 trillion. Lower investment means lower capital stock which means lower potential GDP.

Supply-Side Economics Supply-siders propose lowering personal and corporate taxes on interest and capital income in order to increase saving and investment. Supply of loanable funds shifts to the right, interest rates are lower and investment increases. Capital stock increases and potential GDP increases. LAS shifts to the right. Classroom activity Check out Economics in Action: Some Real-World Tax Wedges

Supply-siders argue for lower tax rates which increase saving and investment. real interest rate SLF SLF lower tax rate A 4% B 3% DLF $1.8 $2.0 loanable funds (Trillions$)

Impact on Potential GDP LAS0 LAS1 P0 A P1 B AD0 Ypot Y Increased Investment => capital stock increases and potential GDP increases. LAS shifts to the right.

Supply-Side Effects of Fiscal Policy What about Budget Deficits? Cut T and hold G fixed => increase in budget deficit Government needs to borrow more. The demand for loanable funds increases => interest rates increase => crowding out.

The Supply-side Debate Before 1980 few economist paid attention to supply side effects. Reagan and supply siders argued the virtues of cutting taxes. They argued tax cuts would increase employment and growth AND argued tax revenues would increase and the budget deficit would decrease. Reagan cut taxes, the economy expanded but the budget deficit increased.

Generational Effects of Fiscal Policy Generational Accounting and Present Value Generational accounting is an accounting system that measures the lifetime tax burden and benefits of each generation. Social Security taxes are paid by people with jobs. Social Security benefits are paid to people after they retire. So to compare the value of an amount of money at one date (working years) with that at a later date (retirement years), we use the concept of present value. A present value is an amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account.

Generational Effects of Fiscal Policy For example: If the interest rate is 4% percent a year, $1,000 invested today (2017) will grow, with interest, to $7,107 after 50 years, calculated as $1,000 x (1.04)50 The present value of $7,107 in 2067 is $1,000. Calculated as: 7,107/(1.04)50. We say the present value of $7,107 received 50 years from now is $1,000. Small differences in interest rates affect the result dramatically. If the interest rate is 3%: PV = 7,107/(1.03)50 = $1,621 Because of the uncertainty, economist must present a range of estimates.

Generational Effects of Fiscal Policy The Social Security Time Bomb Social Security set up under the New Deal in the 1930s. Using generational accounting and present values, economists have determined the federal government is facing a Social Security time bomb! In 2008, the first of the baby boomers started collecting Social Security and by 2030, all the baby boomers will have reached retirement age The population supported by Social Security will have doubled.

Generational Effects of Fiscal Policy The federal government has an obligation to pay To assess the full extent of the government’s obligations, economists use the concept of fiscal imbalance. Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. Economists estimate the fiscal imbalance was $68 trillion in 2014. - 4 times 2014 GDP of $17 trillion.

The Social Security Time Bomb Alternative solutions: Raise Social Security taxes Raise income taxes Cut Social Security Benefits Increase Eligibility Age Cut Federal Government discretionary spending. Print money – argh!

Fiscal Stimulus Can Be Either Automatic Discretionary Automatic fiscal policy is a fiscal policy action triggered by the state of the economy with no government action. Discretionary fiscal policy is a policy action that is initiated by an act of Congress.

Fiscal Stimulus Two items in the federal government budget change automatically in response to the state of the economy: Tax revenues - we have an income tax system unemployment benefits - Needs-tested spending

Automatic Changes in Tax Revenues Congress sets the tax rates (t) that people must pay. The tax dollars people pay depend on tax rates and incomes: T = t x Y. So tax revenues depend on real GDP. When real GDP increases in an expansion, government tax revenues automatically increase. When real GDP decreases in a recession, tax revenues automatically decrease.

Needs-Tested Spending The government has programs that automatically pay benefits (transfer payments) to qualified people and businesses. These transfer payments depend on the economic state of the economy. When the economy is in an expansion, unemployment falls, so unemployment benefits (needs-tested spending) decreases. When the economy is in a recession, unemployment rises, unemployment benefits increases.

Automatic Stabilizers. These automatic changes are called Automatic Stabilizers. In a recession, tax receipts decrease and outlays increase. So the budget provides an automatic stimulus that helps reduce the recessionary gap. In a boom, tax receipts increase and outlays decrease. So the budget provides automatic restraint that helps reduce the inflationary gap.

Fiscal Stimulus –Expansionary Fiscal Policy Discretionary Fiscal Policy - Chapters 10-12 Most discretionary fiscal stimulus focuses on its effects on aggregate demand. Changes in government expenditure and taxes change aggregate demand and have multiplier effects. Two main fiscal multipliers are Government expenditure multiplier Tax multiplier Classroom activity Check out Economics in Action: The 2009 Fiscal Stimulus Package

Discretionary Fiscal Policy a recessionary gap - $1 trillion in this example. An increase in government expenditure or a tax cut increases aggregate expenditure. The multiplier process increases aggregate demand even more.

Which effect is stronger? But…….. an increase in government expenditure increases government borrowing and raises the real interest rate. With the higher cost of borrowing, investment decreases, which partly offsets the increase in government expenditure – crowding out. Which effect is stronger? Statement page 339: “The consensus is that the crowding-out effect is strong enough to make the government expenditure multiplier less than 1”. Need to be careful here. What’s the Fed doing? If the Fed lets interest rates rise, the multiplier may be <1. If the Fed prevents interest rates from rising, multiplier >1.

Tax multiplier The tax multiplier is the quantitative effect of a change in taxes on aggregate demand. “The demand-side effects of a tax cut are likely to be smaller than an equivalent increase in government expenditure”. That is the tax multiplier < government spending multiplier. Classroom activity Check out Economics in Action: How Big Are the Fiscal Stimulus Multipliers?

Fiscal Stimulus and Aggregate Supply Do tax cuts have supply-side effects? Will labor supply increase? Will saving and investment increase? Will LAS shift to the right increasing growth and potential GDP? Economics in Action, pp. 340 and 341, refers to 3 studies that indicate: “the supply-side effects of a tax cut probably dominate the demand-side effects and make the tax multiplier larger than the government expenditure multiplier.” This is what economist debate about. Also, you can see where politics can come into play? Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government expenditures shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the differences between the potential of fiscal policy under a parliamentary system and under the more rigid U.S. system; the length of time it took the congress to pass the 2002 ‘stimulus’ package, compared to almost immediate executive-initiated changes to fiscal policy in Britain, make the point that discretionary fiscal policy is feasible under some governmental systems but only in extreme circumstances in the world’s largest economy.

Problems with using Fiscal Policy for Stabilization Uncertainty about size of the fiscal multipliers Economists have diverging views about the size of the fiscal (government spending and tax) multipliers because there is insufficient empirical evidence on which to pin their size with accuracy. This makes it hard, if not impossible, to determine the amount of stimulus needed to close a given output gap. Uncertainty about size of the output gap The actual output gap is not known and can only be estimated with error – What’s potential GDP? Its an estimate! So discretionary fiscal policy is risky.

More Problems with Fiscal Policy Time Lags The use of discretionary fiscal policy is also seriously hampered by three time lags: Recognition lag - the time it takes to figure out that fiscal policy action is needed. Law-making (Implementation) lag - the time it takes Congress to pass the laws needed to change taxes or spending. Impact (Response) lag - the time it takes from passing a tax or spending change to its effect on real GDP being felt.

Possible Stabilization Timing Problems Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. t0 to t1 is recognition lag, t1 to t2 is implementation, t2 to t3 is response lag. Hence, the policy pushes the economy to points E and F (instead of points E and F). Income varies more widely than it would have if no policy had been implemented.

Can Overshoot Real Income Target P AS G↑ by $200b I↑ Ptarget AD2 P0 AD1 AD0 Y Y0 Ytarget Target ΔY=400