Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 11 Fiscal Policy

11-2 Chapter Objectives Fiscal policy Short-term impact of government spending The multiplier effect Limitations of spending stimulus Taxation Incentives and taxes Budget deficits and surpluses

11-3 Fiscal Policy Fiscal policy is defined as the economic effect of government spending and taxes. Looks at the impact on the economy in both short-term and long-term. In the short-term, fiscal policy consists of the government’s budget decisions. In the long-term, fiscal policy creates the link between government spending and taxation decisions and the country’s economic growth.

11-4 Government and Economy Government spending and tax policy have a major impact on the economy. Government spends directly on wages, goods and services. It also shifts money from some people to others in the form of Social Security, Medicare, and other programs.

11-5 Government and Economy In the private sector, spending occurs through market transactions. –In this case, all transactions are voluntary. The level of government spending is set by the political system, rather than the economic system. Spending is funded through a combination of taxation and borrowing. –Unlike private sector, the government pays back debts by raising taxes.

11-6 Short-Term Impact of Government Spending Each year the federal budget is set in the process that begins in February. Eventually the President and Congress come to an agreement on the level of spending and the tax rules. In the short term, an increase in government spending lowers unemployment and increases GDP, all other things being equal.

11-7 Short-Term Impact of Government Spending Demand curve for labor after increase in government spending L1L1 W1W1 Original demand curve for labor Wage L Quantity of labor supplied and demanded Supply curve for labor W A B

11-8 Short-Term Impact of Government Spending The use of increases in government spending and tax cuts to stimulate the economy and combat the effects of recession is called the Keynesian approach. This approach was developed by John Maynard Keynes as a solution to the economic problems caused by the Great Depression. Increases in government spending and cuts in taxes are called fiscal stimulus.

11-9 The Multiplier Effect The total economic impact of government spending is greater than the initial amount of spending. –A government contract to build a new bridge leads to hiring of construction workers. However, the economic impact doesn’t end there. These workers spend some of their paychecks in the local economy. –This spending leads to additional hiring by local businesses, and further boosts the economy.

11-10 The Multiplier Effect Thus, the first round of spending creates income that generates a second round of spending and this induces a third round. The multiplier effect is the overall boost in economic activity that flows from the increase in government spending. We can state the multiplier as either a job or spending multiplier.

11-11 The Multiplier Effect –If the job multiplier is 2, this means that each new government job creates one new private sector job. –Suppose government spending rises by $100 billion. A spending multiplier of 1.5 means that GDP goes up by $150 billion – including $100 billion from the initial spending and $50 billion due to the follow-up effects. The multiplier process also works in reverse, so cuts in spending lead to job losses and lower GDP.

11-12 Marginal Propensity to Consume The question is, what determines the size of the multiplier? –The main factor is the marginal propensity to consume (MPC), or the portion of each additional dollar of income that consumers spend. –MPC takes on values of 0 to 1. –In general, low income households have a MPC close to 1. –In contrast, the richest households tend to have a low MPC.

11-13 Marginal Propensity to Consume –The multiplier will be higher if the government spending goes to people with a high marginal propensity to consume. A government project that hires unemployed workers into long-term jobs will generally have a big multiplier effect, because these workers are likely to spend a lot of their wages. But a program that hands out money to rich Americans is likely to have only a small impact on GDP.

11-14 Overseas Leakage Another factor affecting the multiplier is the amount of money spent on US-produced goods versus foreign goods, or imports. In order to boost GDP, government spending must increase production in the United States. But in a world where more products are made overseas, it is possible that fiscal stimulus will lead to increased imports, rather than to faster growth at home. –This transfer of domestic economic stimulus to foreign markets is known as overseas leakage.

11-15 The Size of the Multiplier The multiplier depends on the value of MPC and percentage of income consumers spend on imported goods. Given these factors, most economists believe the value of the job and spending multipliers are between 1 and 2. Note: If the multiplier is below 1, it means that higher government spending actually causes the private sector to contract.

11-16 Limitations of Spending Stimulus There are downsides to stimulating the economy through fiscal policy. These limit the extent to which government can use spending to stimulate the economy. The first limitation in attempting to use government spending is inflation. –In the short-term, an increase in government spending raises wages and prices.

11-17 Limitations of Spending Stimulus If actual GDP is above potential GDP, then increases in government spending will mostly turn into inflation. But if unemployment is high and actual GDP is below potential GDP, then increased government spending is more likely to turn into higher output.

11-18 Limitations of Spending Stimulus A second limitation is due to lags in policy. –It takes time to recognize that the economy is in a recession and then pass the appropriate legislation. –If the spending comes when the economy is already out of recession, then it actually adds to inflation.

11-19 Taxation The main source of revenues for government spending is taxation. The table on the next slide lists the various taxes used to raise revenues. Compared to the size of the economy, tax collections have not changed much over the last 30 years.

11-20 Taxation Name of taxSource of tax Income taxIndividual income Property taxThe value of commercial and residential real estate Payroll taxWage payments Corporate income taxCorporate profits Sales taxRetail sales Excise taxItems such as gasoline, tobacco and alcohol

11-21 Taxation versus GDP

11-22 Federal Income Taxes

11-23 Direct Impact Of Taxes Disposable income is defined as the amount of income people have left after paying taxes. Tax cuts increase disposable income, while tax increases lower it. Thus, tax cuts are stimulative, and tax increases are contractionary. If the economy goes into recession, the government can cut taxes as a way of stimulating the economy.

11-24 Direct Impact Of Taxes Demand curve for cars after income tax cuts Q1Q1 P1P1 Original demand curve for cars Price of cars Q Quantity of cars supplied and demanded Supply curve for cars P A B

11-25 Incentives and Taxes There are incentive effects associated with taxes. Higher taxes will discourage whatever activity is being taxed. This link between taxes and incentives is the essential insight of supply-side economics. Supply-side economics focuses on the marginal tax rate - that is, the tax you pay on the last dollar of income you earn.

11-26 Incentive Effect of Taxes L1L1 Pre-tax wage paid by employer Wage L Quantity of labor supplied and demanded Supply curve for labor After-tax wage received by employee Tax Reduced taxOriginal tax W1W1 W

11-27 Top Marginal Tax Rate

11-28 Borrowing If there is a gap between spending and tax revenues, the government has to borrow. The excess of the federal government’s spending over its revenues is the budget deficit. If revenues exceed spending, we have a budget surplus. To pay for the budget deficit, the government borrows money from investors. The total of all the government’s borrowing is called the public debt.

11-29 Federal Budget Surplus or Deficit

11-30 Effect of Borrowing In the short run, an increasing federal budget deficit stimulates the economy. Government borrowing has a negative effect, in that a rising budget deficit pushes up interest rates and crowds out private investment. This is known as crowding out. Crowding out has a negative impact on long-term growth.

11-31 Crowding Out New demand curve for loans, including government borrowing L1L1 r1r1 Demand curve for loans Interest rate L Quantity of money borrowed and lent Supply curve for loans r A B

11-32 Summary of Impacts of Fiscal Policy Fiscal Policy ActionHow can it help?How can it hurt? Increase government spending Create jobs and boost GDP Can boost inflation and widen budget deficit. Lower taxesCreate jobs and boost GDP, incentives for work and investment Can boost inflation and widen budget deficit. Accept wider budget deficit Create jobs and boost GDP Can lead to higher interest rates and lower private investment; lowers long-term GDP growth.