UNIT V: FISCAL POLICY What can the government do to help fight the economic enemies of Recession/Depression and Inflation? Part I: Fiscal Policy Part II: Taxes Part III: Debt

Part I: Fiscal Policy

What is fiscal policy? It’s the government’s power to TAX AND SPEND in order to regulate the economy The fiscal year runs from October 1 to September 30

Where does fiscal policy come from? Where does fiscal policy come from? 1936: John Maynard Keynes develops his “General Theory” in his book The General Theory of Employment, Interest, and Money. Why does the actual production in an economy sometimes fall short of its productive capacity? Thus was born the Keynesian Revolution

2 Ways to be an Economist: ClassicalKeynesian

Classical: Economy will have its ups & downs (a general flow) Keep gov’t out of business; leave it along Things will work themselves out…

Keynesian: John Maynard Keynes said economy was more like an elevator If elevator is stuck, you need to intervene (emergency buttons?!) Increase spending to stimulate demand

Who was John Maynard Keynes? Gov’t advisor, teacher, journalist Revolutionized economic theory Influenced wartime and post-war economic policy New Deal Economics: Demand Side Economics/(Keynesia n)

Keynesian vs. Classical Economics KeynesianClassical Examines the productive capacity of the economy as a whole No self-correcting method!!!!!!!!! The answer: SPEND FDR agreed! Examined the equilibrium of supply and demand for individual products

Fiscal Policy and Aggregate Demand Fiscal policy will regulate aggregate demand What is aggregate demand? How is aggregate demand calculated? THE TARGET: AGGREGATE DEMAND

AND/OR….increase or decrease the government’s spending (g) Demand-Side Economics Supply-Side Economics Lower taxes for consumers which will in turn increase the purchasing power of the consumer (Keynesian) Lower taxes for businesses to encourage industries to invest (increases aggregate supply)

The Government’s Role ExpansionaryContractionary Increase government spending or cut taxes to increase demand Output Employment Decrease spending or raise taxes to decrease or slow demand Why? When demand exceeds supply, producers must choose between raising output or raising prices

Type of fiscal policy Change in government spending Change in taxes ExpansionaryAnd/Or ContractionaryAnd/Or Types of Fiscal Policy

How can we stabilize the economy? Discretionary Stabilizers Automatic Stabilizers ◦ The deliberate manipulation of taxes & gov’t spending by Congress – (government makes/changes laws)  Increase/Decreases taxes & spending Policy change happens by itself as the economy changes ◦ Unemployment Compensation ◦ Progressive Income Taxes

Discretionary Policies: I. EXPANSIONARY: ◦ Why?  Jumpstart the economy by stimulating demand ◦ How?  Increase gov’t spending  Decrease taxes ◦ When Used?  During a recession

Effects of Expansionary Fiscal Policy Total output in the economy High outputLow output High prices Low prices Price level Aggregate supply Original aggregate demand Lower output, lower prices Higher output, higher prices Aggregate demand with higher government spending Expansionary Fiscal Policies Increasing Government Spending If the federal govt increases its spending or buys more goods & services, it triggers a chain of events that raise output & creates jobs. Cutting Taxes When the govt cuts taxes, consumers & businesses have more money to spend or invest. This increases demand & output.

CONTRACTIONARY: ◦ Why?  “cool” down economy  Slow down demand ◦ How?  Decrease spending  Increase taxes ◦ When?  Inflationary Times Discretionary Policies:

Effects of Contractionary Fiscal Policy Total output in the economy High outputLow output High prices Low prices Price level Aggregate supply Higher output, higher prices Original aggregate demand Lower output, lower prices Aggregate demand with lower government spending Contractionary Fiscal Policies Decreasing Government Spending If the federal govt spends less, or buys fewer goods & services, it triggers a chain of events that may lead to slower GDP growth. Raising Taxes If the federal govt increases taxes, consumers & businesses have fewer dollars to spend or save. This also slows growth of GDP.

The Effectiveness of Fiscal Policy ObjectivePolicy Condition existing Does the policy affect total spending in the economy? Does the policy meet the objective (as stated in the 1 st column)? Reduce unemployment Expansionary fiscal policy (as measured by an increase in govt spending) No crowding out YES Complete crowding out NO Incomplete Crowding out YES Reduce inflation Contractionary fiscal policy (as measured by an decrease in govt spending) No crowding in YES Complete crowding in NO Incomplete Crowding in YES

Part II: Taxes

Why do we pay taxes?

What kinds of taxes are there? Federal Income Tax (W-2, W-4, etc.) Excise Taxes Estate Taxes FICA Capital Gains Taxes Corporate Income Taxes

What is a “Fair Tax”? 1. It is proportional to income 2. It is clear and comprehendible 3. It is economically efficient 4. It is flexible

George W. Bush’s Tax Plan ( ) Lowered taxes across the board (25-35%) Eliminated the marriage penalty Increased yearly IRA contributions Increased the child credit MORE DISPOSABLE INCOME!!!

What is the “Flat Tax” Proposal? Flat tax of 17% on all Americans No Deductions (except children) Family of 4 would have to earn $36,800 before income tax Armey-Shalby Tax: Freedom and Fairness Restoration Act

3 Kinds of Effective Tax Rates - Progressive Tax: tax rate increases as a person’s income goes up (income tax) - Proportional Tax: tax rate remains the same regardless of income (FICA) - Regressive Tax: tax rate “decreases” as income goes up. (Larger proportions of earnings come from people with lower incomes) Effective Tax Rate: The % of your income you pay in taxes

Engels Law Ernst Engel, German Statistician The lower a family’s income, the greater the % the family has to spend on the necessities of life. Proportional taxes are a burden to lower income families

Part III: Budgets, Deficits, and Surpluses

Why would we spend money we don’t have? War today = Freedom tomorrow Interest rates on U.S. savings bonds, Treasuries, etc. go back to Americans-for the most part Multiplier Effect! Expansion = More Expansion Technology for future (AJH 2013) It is part of our social obligation to take care of the less fortunate (Medicare, Medicaid, Head Start, etc.

The Multiplier Effect

Why should we avoid deficit spending? Passing on the debt to future generations It fuels inflation National Security Risk: 47% of our national debt is owed to foreigners Deficit spending increases our national debt 13 cents/$1.00 goes to paying off the interest on our national debt!

What is the national debt? National debt is the accumulated deficits that add up over the years

Why the Government has a dilemma… Policies that are put into place to bring down inflation will also increase unemployment

The Phillips Curve? Why is lowering inflation problematic for achieving our economic goals?

Who pays for the cost of running the government? Budget Levels: 1. Federal (U.S.) 2. State 3. Local 1.All levels must develop budgets with taxes and spending in mind.

Budget Terms Surplus Budget: revenues exceed expenditures Deficit Budget: expenditures exceed revenues Fiscal Year: October 1 - September 30 th

How do budgets get “bloated”? “Earmarks” – many Congressional representatives hold major revenue bills hostage with “earmarks” for their home districts “Pork Barrel Legislation”

What if the deficit starts going down? BE WORRIED!!!!!!!! 78 Millions Baby Boomers will soon need: - Social Security-Medicare -Medicare will pay more this year than it will take in -Social Security will pay out more than it takes in 2017

Historical Efforts to Cut the Budget Gramm-Rudman Hollings Act Balance Budget Amendment (1995) Limit deficit to $100 bil in 1990 Limit deficit to $64 bil in 1991 Limit deficit to $28 bil in 1992 Balance budget by 1993 Required federal budgets to be balanced before they became law Failed by one vote in the Senate

Who prepares the Budget? OMB: Office of Management and Budget in Executive Office Congress has the final say Most likely, the budget that gets passed will be very different from the one the president proposed.

The Federal Budget Q: What is the single largest federal expenditure? A: Entitlement Programs Q: What is the largest single source of revenue? A: Federal Income Tax

The State Budget Q: What is the largest source of revenue for the state? A: Sales Tax Q: What is the largest expenditure on the state level? A: Education (Social Security is #2)

The Local Budget Q: What is the largest source of revenue on the local level? A: Property Taxes Q: What is the largest expenditure on the local level? A: School Budget