1. Fiscal Policy Chapter 12

2. Expansion and Contraction with Fiscal Policy Expansionary Policy (Stimulus) – Increase Government Purchases – Increase Transfer Payments – Reduce Taxes 2 Copyright © Houghton Mifflin Company. All rights reserved.

3. Expansion and Contraction with Fiscal Policy Contractionary Policy (Resist inflation) – Reduce Government Purchases – Reduce Transfer Payments – Increase Taxes 3 Copyright © Houghton Mifflin Company. All rights reserved.

4. 4 Demand-Side Policy: Increased Spending Increases Aggregate Demand: a la Keynes Real GDP Price Level (c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.) AD 1 AD  Y?

5. 5 Copyright © Houghton Mifflin Company. All rights reserved. Spending Multiplier $1 Increased Spending is multiplied by the Spending Multiplier Spending Multiplier: __1__ Leakages Note: leakages are: saving rate + import rate (all stated in their decimal forms)

6. 6 Copyright © Houghton Mifflin Company. All rights reserved. Analysis of a Tax-and-Spend Policy Government increases spending, but finances it with tax increases. The increase in spending shifts AD to the right, but the increase in taxes reduces the incentive to work, shift AS to the left.

7. 7 Copyright © Houghton Mifflin Company. All rights reserved. Ricardian Equivalence Thesis If Government increases spending without increasing taxes, consumers and firms recognize that future taxes must rise. Therefore, they save more now and reduce private spending. The increased savings cancels out the increased government purchases in their effect on AD. Increased Govt. Spending will have no positive impact on AD. – David Ricardo proposed this, and then rejected it in the 1800s. Some (few) economists now assert its relevance again.

8. 8 Copyright © Houghton Mifflin Company. All rights reserved. Crowding Out The issue of crowding out is usually raised in the context of increased government spending (G) financed by the issue of debt. Essentially, the government borrows the money it will spend. The government’s demand for credit drives up interest rates.

9. 9 Copyright © Houghton Mifflin Company. All rights reserved. Crowding Out (cont.) Higher interest rates result in higher financing costs for firms, and therefore lower investment spending, offsetting (partially or fully) the GDP gains from the increase in government spending. That is, private investment is “crowded out” by debt-financed public (gov’t) spending.

10. 10 Copyright © Houghton Mifflin Company. All rights reserved. Other implications of Budget Deficits and National Debt The crowding out of private investment means a smaller future capital stock. This implies lower output in the future. Higher interest rates will also cause the currency to appreciate, making foreign currencies and goods cheaper. Imports increase, hence net exports decrease, reducing GDP. This is international crowding out. The higher the national debt (rising because of budget deficits), the higher the interest payments (debt service) paid by the government.

11. 11 Copyright © Houghton Mifflin Company. All rights reserved. The Making of U.S. Fiscal Policy

12. 12 Copyright © Houghton Mifflin Company. All rights reserved. Complications of Fiscal Policy Lag times – Recognition Lag – Policy decision Lag – Implementation Lag – Impact lag A discretionary fiscal policy (one that is NOT an automatic stabilizer) has such long lag times as to be ineffective as a response to cyclical macroeconomic conditions.

13. 13 Copyright © Houghton Mifflin Company. All rights reserved. Complications of Fiscal Policy Electoral incentives – Expansionary policy is easy Tax cuts Spending increases – Contractionary policy is difficult Tax increases Spending cuts – Bias for inflationary over-stimulation – Tendency to run deficits

14. 14 Copyright © Houghton Mifflin Company. All rights reserved. U.S. Government Revenues and Expenditures

15. 15 Copyright © Houghton Mifflin Company. All rights reserved. U.S. Government Expenditures as a Percentage of GDP

16. 16 Copyright © Houghton Mifflin Company. All rights reserved.

17. 17 Copyright © Houghton Mifflin Company. All rights reserved.

18. 18 Copyright © Houghton Mifflin Company. All rights reserved. Updated National Debt/Deficit Data

19. 19 Copyright © Houghton Mifflin Company. All rights reserved. More Updated Data on US Debt

20. 20 Copyright © Houghton Mifflin Company. All rights reserved. Fiscal Policy Demand-side policies: policies designed to stimulate or slow aggregate demand (focusing on Consumption & Government purchases). Supply-side policies: policies designed to stimulate or slow aggregate demand (focusing on Investment).

21. 21 Copyright © Houghton Mifflin Company. All rights reserved. Fiscal Policy Discretionary Fiscal Policy: changes in government spending and/or taxation aimed at achieving a policy goal. Automatic Stabilizer: an element of fiscal policy that changes automatically as income changes.

22. 22 Copyright © Houghton Mifflin Company. All rights reserved. Taxes Two types of taxes: – direct taxes: on individuals and firms. For example, personal income taxes, business income taxes, SSI, FICA – indirect taxes: on goods and services. For example, sales taxes, and value- added taxes (VAT).

23. 23 Copyright © Houghton Mifflin Company. All rights reserved. Taxes Three types of tax rate structures: – progressive tax: rate increases with higher income; wealthy pay a higher percentage. (examples: federal income tax, CA state income tax) – regressive tax: rate falls with higher income; wealthy pay a lower percentage. (examples: SSI, FICA, sales tax, gasoline tax, VAT) – proportional tax: rate is constant; everyone pays the same percentage. (for example a 10% flat tax – no real examples in US)

24. 24 Copyright © Houghton Mifflin Company. All rights reserved. Automatic Stabilizers Progressive Taxes – As income falls, the tax rate also falls, helping to maintain buying power, hence maintaining aggregate demand Income taxes Corporate income taxes Capital gains taxes

25. 25 Copyright © Houghton Mifflin Company. All rights reserved. Automatic Stabilizers Transfer Payments: Insure that buying power is not reduced at the same rate as income – Unemployment insurance – Welfare – Subsidies (farm income supports, etc.)

26. 26 Copyright © Houghton Mifflin Company. All rights reserved. Demand-Side Policy: Increased Spending Increases Aggregate Demand Real GDP Price Level (c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.) AD 1 AD  Y?

27. 27 Copyright © Houghton Mifflin Company. All rights reserved. Aggregate Demand and Supply Equilibrium

28. 28 Copyright © Houghton Mifflin Company. All rights reserved. Central Government Spending by Functional Category

29. 29 Copyright © Houghton Mifflin Company. All rights reserved. Central Government Tax Composition by Income Group

30. 30 Copyright © Houghton Mifflin Company. All rights reserved. Central Government Tax Composition by Income Group

31. 31 Copyright © Houghton Mifflin Company. All rights reserved. Supply-Side Economics and the Laffer Curve Taxes are a disincentive to productive activity. As marginal tax rates rise, the disincentive effects also grow, shrinking the tax base. At marginal tax rates greater than t, the tax base shrinks at a faster rate than the increases in marginal tax rate. The net result is that increases in marginal tax rates beyond t result in reduced tax revenues.

32. 32 Copyright © Houghton Mifflin Company. All rights reserved. The Laffer Curve and Public Policy Reagan Administration argument: Taxes were too high, reduce taxes and revenue will increase. – Reduced Corporate and higher income taxes – Increased Government spending – Result: Growing GDP, but with rising deficits, rising debts G.W. Bush Administration: Same argument, same result – Reduced corporate and higher income taxes – Increased spending – Result: Growing GDP, but with rising deficits, rising debts

33. 33 Copyright © Houghton Mifflin Company. All rights reserved. US Taxes In Comparison Marginal Income Tax Rates: US: 15% - 28% (top bracket reduced in 2002 from 39.6%) Japan: 10% - 40% UK: 10% - 40% Germany: 23.9%-53% France: 10.5% - 54%