1 of 25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e.

2 of 25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e.

3 of 25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. Fiscal Policy F ERNANDO Q UIJANO, Y VONN Q UIJANO, AND X IAO X UAN X U P R E P A R E D B Y The conventional wisdom among both politicians and economic policymakers for years was that active use by the government of changes in spending and taxes could play only a limited role in fighting recessions. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 4 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. A P P L Y I N G T H E C O N C E P T S 1 2 Why are the United States and many other countries facing dramatically increasing costs for their government programs? Increasing Life Expectancy and Aging Populations Spur Costs of Entitlement Programs How are tax rates and tax revenues related? The Confucius Curve? Did the 2001 tax cuts stimulate consumer spending? Were the 2001 Tax Cuts Spent or Saved? 3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 5 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. Fiscal Policy fiscal policy Changes in government taxes and spending that affect the level of GDP.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 6 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE ROLE OF FISCAL POLICY 10.1 Fiscal Policy and Aggregate Demand FIGURE 10.1 Fiscal Policy in Action Panel A shows that an increase in government spending shifts the aggregate demand curve from AD 0 to AD 1, restoring the economy to full employment. This is an example of expansionary policy. Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD 0 to AD 1, restoring the economy to full employment. This is an example of contractionary policy.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 7 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE ROLE OF FISCAL POLICY 10.1 Fiscal Policy and Aggregate Demand expansionary policies Government policy actions that lead to increases in aggregate demand. contractionary policies Government policy actions that lead to decreases in aggregate demand.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 8 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE ROLE OF FISCAL POLICY 10.1 The Fiscal Multiplier stabilization policies Policy actions taken to move the economy closer to full employment or potential output. The Limits to Stabilization Policy As the government develops policies to stabilize the economy, it needs to take the multiplier into account. The total shift in aggregate demand will be larger than the initial shift. As we will see later in this chapter, U.S. policymakers have taken the multiplier into account as they have developed policies for the economy.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 9 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE ROLE OF FISCAL POLICY 10.1 The Limits to Stabilization Policy LAGS FIGURE 10.2 Possible Pitfalls in Stabilization Policy Panel A shows an example of successful stabilization policy. The solid line represents the behavior of GDP in the absence of policies. The dashed line shows the behavior of GDP when policies are in place. Successfully timed policies help smooth out economic fluctuations. Panel B shows the consequences of ill-timed policies. Again, the solid line shows GDP in the absence of policies and the dashed line shows GDP with policies in place. Notice how ill-timed policies make economic fluctuations greater.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 10 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE ROLE OF FISCAL POLICY 10.1 The Limits to Stabilization Policy LAGS inside lags The time it takes to formulate a policy. outside lags The time it takes for the policy to actually work. FORECASTING UNCERTAINTIES What makes the problem of lags even worse is that economists are not very accurate in forecasting what will happen in the economy.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 11 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 Federal Spending

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 12 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 Federal Spending discretionary spending The spending programs that Congress authorizes on an annual basis. entitlement and mandatory spending Spending that Congress has authorized by prior law, primarily providing support for individuals.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 13 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 Federal Spending Social Security A federal government program to provide retirement support and a host of other benefits. Medicare A federal government health program for the elderly. Medicaid A federal and state government health program for the poor.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 14 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. Today, Social Security, Medicare, and Medicaid constitute approximately 9 percent of GDP. Experts estimate that in 2075 spending on these programs will be approximately 21 percent of GDP. How will our society cope with increased demands for these services? Possible solutions: Leave the existing programs in place and just raise taxes to pay for them. The government should save and invest now to increase GDP in the future to reduce the burden on future generations. Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being. Reform the health-care system to encourage more competition to reduce health-care expenditures. INCREASING LIFE EXPECTANCY AND AGING POPULATIONS SPUR COSTS OF ENTITLEMENT PROGRAMS APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing costs for their government programs? A P P L I C A T I O N 1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 15 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 Federal Revenues

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 16 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 Federal Revenues supply-side economics A school of thought that emphasizes the role that taxes play in the supply of output in the economy. Laffer curve A relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged. SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 17 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. While the idea that cutting tax rates might actually increase tax revenue is often attributed to economist Arthur Laffer, in fact, it is actually a much older idea than that. Yu Juo, one of the twelve wise men who succeeded Confucius in ancient China, was asked what should be done in the case of a famine if the government had insufficient funds. He replied that the tax rate should be cut to 10 percent. Skeptical government bureaucrats did not have enough funds at a 20 percent rate, so how could they cut it to 10 percent? Yu Juo replied, Cutting taxes and limiting your expenses allow people to raise their standard of living. Afterwards, you will no longer need to worry about famine and shortage. Revenue estimators in Washington, D.C, do not share entirely in Yu Juos wisdom, but they do recognize that cutting tax rates will stimulate economic activity. THE CONFUCIUS CURVE? APPLYING THE CONCEPTS #2: How are tax rates and tax revenues related? A P P L I C A T I O N 2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 18 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 The Federal Deficit and Fiscal Policy budget deficit The amount by which government spending exceeds revenues in a given year. budget surplus The amount by which government revenues exceed government expenditures in a given year.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 19 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 Automatic Stabilizers automatic stabilizers Taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action. The increased federal budget deficit works through three channels: 1 Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income. 2 Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much. 3 Because the corporation tax depends on corporate profits and profits fall in a recession, taxes on businesses also fall. Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 20 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. THE FEDERAL BUDGET 10.2 Are Deficits Bad?

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 21 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. FISCAL POLICY IN U.S. HISTORY 10.3 The Depression Era The Kennedy Administration During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits. According to Brown, fiscal policy was expansionary only during two years of the Great Depression, 1931 and Although modern fiscal policy was not deliberately used during the 1930s, the growth in military spending at the onset of World War II in 1941 increased total demand in the economy and helped pull the economy out of its long decade of poor performance. But to see fiscal policy in action, we need to turn to the 1960s. It was not until the presidency of John F. Kennedy during the early 1960s that modern fiscal policy came to be accepted.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 22 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. FISCAL POLICY IN U.S. HISTORY 10.3 The Vietnam War Era permanent income An estimate of a households long-run average level of income. The Reagan Administration The tax cuts enacted during 1981 at the beginning of the first term of President Ronald Reagan were significant. However, they were not proposed to increase aggregate demand. Instead, the tax cuts were justified on the basis of improving economic incentives and increasing the supply of output.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 23 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. FISCAL POLICY IN U.S. HISTORY 10.3 The Clinton and George W. Bush Administrations FIGURE 10.3 Federal Taxes, Spending, and Deficits, 1996–2006

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 24 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. According to conventional economic theory, a permanent cut in taxes should largely be spent by households because it represents a new permanent source of income for them. WERE THE 2001 TAX CUTS SPENT OR SAVED? APPLYING THE CONCEPTS #3: Did the 2001 tax cuts stimulate consumer spending? To discover whether households actually spent the tax cuts, professors Matthew Shapiro and Joel Slemrod decided to ask some of them. Result: Fewer than 25 percent of households were likely to spend the rebate. Moreover, low-income households were no more likely to spend the rebate than higher-income households. These survey results may not reflect the actual behavior of consumers. The Congressional Budget Office reviewed other studies that directly examined consumer spending after the rebates. Result: Financially strapped households do spend any tax cuts they receive. A P P L I C A T I O N 3 In 2001, approximately 90 million U.S. households received tax rebate checks from the government.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. C H A P T E R 10 Fiscal Policy 25 of 25 Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. automatic stabilizers budget deficit budget surplus contractionary policies discretionary spending entitlement and mandatory spending expansionary policies fiscal policy inside lags Laffer curve Medicaid Medicare outside lags permanent income Social Security stabilization policies supply-side economics K E Y T E R M S