1. Fiscal Policy
Chapter 31 Notes

2. The Federal Budget
Federal Budget: An annual statement of the revenues, outlays, and surplus or deficit of the government of the United States
Two Purposes
To finance the activities of the federal government (only purpose until Great Depression)
To achieve macroeconomic objectives (arose as a result of the Great Depression)

3. The Federal Budget Made by the President and Congress
Proposed by President between the first Monday of January and the first Monday in February for the next fiscal year
Passed by Congress
Fiscal Year: October 1 – September 30
You can learn about the federal budget at budget.house.gov

4. Budget Balance = Tax Revenues – Government Expenditures

5. Budget Balance
Budget Surplus: when tax revenues exceed government expenditures
Balanced Budget: when tax revenues equal government expenditures
Budget Deficit: when government expenditures exceed tax revenues

6. Sources of Government Revenue
Tax Revenues (85%)
Income Taxes
Corporate Taxes
Customs/Duties
Excise Taxes
Social Security Taxes
Medicare Taxes
Other Taxes
Borrowing (15%)

8. From What Countries Does the US Borrow Money?

9. Breakdown of Government Expenditures
US Treasury divides budget into three subcategories
Mandatory Spending: spending on programs required by current law (Transfer Payments: Benefits and Welfare)
Discretionary Spending: spending that can be adjusted yearly
Interest on Debt

13. Calculate the Current Budget Balance
Government Revenues
Tax Revenues
Borrowing
Total Revenue
Government Revenues
Tax Revenues
$3.18 trillion
Borrowing
$0.58 trillion
Total Revenue
$3.76 trillion
Government Expenditures
Discretionary
$1.11 trillion
Mandatory
$2.45 trillion
Interest on Debt
$0.23 trillion
Total Expenditures
$3.79 trillion
Government Expenditures
Discretionary
Mandatory
Interest on Debt
Total Expenditures
Budget Balance
$0.03 trillion
Budget Balance

14. Budget Balances for US

15. During a recession, does the US government typically spend more?
Trick question! The Budget Balance shows BOTH revenues and expenditures. It is unclear as to whether the government is increasing its expenditures (spending more on transfer payments) or just decreasing its revenues (lowering the tax rates or providing more tax breaks)

16. Trick question! The Budget Balance shows BOTH revenues and expenditures. It is unclear as to whether the government is increasing its expenditures (spending more on transfer payments) or just decreasing its revenues (lowering the tax rates or providing more tax breaks)

17. Fiscal Policy
Fiscal Policy: The use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment
Change in Government Expenditures (G)
Change in Government Spending
Change in Transfer Payments
Change in Tax Revenues

18. The Keynesian View
Fiscal stimulus (increase in government spending or a decrease in taxes) boosts real GDP and promotes employment
Fiscal stimulus increases AD
Remember, AD is affected by anything that affects GDP = C + I + G + NX
Spending multiplier (1/MPS) and tax multiplier (MPC/MPS) grow GDP by more than just the change in spending
Fiscal stimulus is a great way to combat recession

19. The Mainstream View
Keynesians overestimate the multiplier effect of fiscal stimulus
The effects of fiscal stimulus are too small and take too long to be useful
Government stimulus crowds out consumption and investment expenditures

20. Government Expenditure Multiplier
When government expenditures increase
AD shifts right, increasing GDP
As a result, C also increases
Government Expenditure Multiplier = 1/MPS (same as the spending multiplier)

21. Government Expenditure Multiplier Example
If the government increases expenditures on education by $10 billion and the MPC = 0.80, how much will GDP increase by?

22. Tax Multiplier
A decrease in taxes increases disposable income, which increases C
Tax multiplier = MPC/MPS

23. Tax Multiplier Example
By how much would you have to decrease taxes in order to raise GDP by $10 billion if MPS = 0.20?

24. Government Expenditure vs. Tax Multiplier
Anshula Venkataraman is working as chief economist at the congressional budget office of Herzoslovakia. The country is falling behind on its growth target and the finance minister, Corentin Denis, is sure he has to convince the congress to provide the required stimulus to the economy. Corentin met with Anshula and told her that according to his estimates the GDP must grow by at least $40 billion in order to achieve the target growth rate. The country is already running a budget deficit and Corentin has requested Anshula’s opinion on whether to decrease taxes or increase government expenditures in order to achieve the target with least increase in the budget deficit.
An assistant of Anshula has estimated that the country has a marginal propensity to save of Draft a response to Corentin’s request on behalf of Anshula.

25. Transfer Payments Multiplier
The effect of a change in transfer payments on AD
An increase in transfer payments increases disposable income, which increases C
Transfer Payments Multiplier = -MPC/MPS (same as the tax multiplier, but in the opposite direction)

26. Balanced Budget Multiplier
The effect on aggregate demand of a SIMULTANEOUS change in government expenditure and taxes that leaves the budget balance unchanged.
What is the effect of a $1 increase in government spending and a $1 increase in taxes?

27. Balanced Budget Multiplier Example
If government spending increases by $20 billion and tax revenues increase by $20 billion, what is the net effect on GDP given an MPC = 0.90?

28. Balanced Budget Multiplier
If both government spending and taxes increase or decrease by the same amount, GDP will increase or decrease by the same amount as the change.
Balanced Budget Multiplier = 1

29. Expansionary Fiscal Stimulus
During a recession, the government can increase spending, decrease taxes, or increase transfer payments to increase AD until LR equilibrium is reestablished.
GDP PL
LRAS
SRAS
PL2
PL1
AD2
AD1 Y1 Y2

30. Contractionary Fiscal Policy
If real GDP is above potential GDP (high inflation), the government can decrease spending, increase taxes, or decrease transfer payments to decrease AD until LR equilibrium is reestablished.
GDP PL
LRAS
SRAS
PL1
PL2
AD1
AD2 Y2 Y1

31. Automatic Fiscal Policy
A fiscal policy action that is triggered by the state of the economy. Known as an Automatic Stabilizer.
Ex: increase in unemployment  increase in transfer payments  increase in C  increase in AD  increase in GDP
Ex: decrease in income  decrease in tax revenues  increase in disposable income  increase in C  increase in AD  increase in GDP

32. Induced Taxes Taxes that vary with real GDP
An example of an automatic stabilizer
As GDP increases, wages increase, which causes taxes on these wages to also increase (remember, the US has a progressive tax system)

33. Discretionary Fiscal Policy
A fiscal policy action that is initiated by an act of Congress
Requires a change in a spending program or in a tax law.
Ex: Increase in defense spending or cuts in the income tax rate

34. The US Tax System
You will not be tested directly on this, but I want to expose you to this since it will affect EVERY single one of you and most people have no idea how it works.

35. US Tax System
Tax Brackets: Income brackets with varying marginal tax rates
Marginal Tax Rate: the rate at a given dollar is taxed. Not all of your income is taxed equally. The US uses a progressive tax system, so each additional dollar gets taxed at a higher rate.
Average Tax Rate: the average rate at which all your money is taxed as compared to your total income.

36. Average Tax Rate The percentage of your total income that is taxed.
Liz earns $100,000 a year. Use the tax bracket table to identify her average tax rate.

37. 2015 Tax Rates Marginal Tax Rate Lower Limit Upper Limit
Average Tax Rate
10% $0
$9,225
15%
$37,450 ?
25%
$90,750
28%
$189,300
33%
$411,500
35%
$413,200
39.6% -
What are the highest and lowest average tax rates a person within a given tax bracket can pay?

38. Trump’s Tax Plan

39. Total Taxes Trump’s Proposal
Will Trump’s tax bracket proposal benefit the rich, the poor, both, or neither?
Income
Total Taxes Old System
Average Tax Rate
Total Taxes Trump’s Proposal
Average Taxes
$5,000
$30,000
$53,000
$125,000
$250,000
$412,000
$500,000
$1,000,000

40. Tax Breaks Discretionary Fiscal Policy
People claim tax breaks (deductions), which lower their taxable income, which could potentially drop them to a lower tax bracket.
Marital Status
Dependents
Mortgage Interest
Educational Loan Interest
Typically the government grants tax breaks to incentivize the public to do things that it deems are socially beneficial.

41. Standard Deduction (Tax Break)
Filing Status
Deduction
Single
$6,300
Married or Widowed with Child
$12,600
Head of Household (single, but with a dependent)
$9,250
Reduces your taxable income.
Taxable income = Income – Deduction

42. Tax Breaks Complete the Tax Breaks activity
What are the effects of granting tax breaks?
Do you believe tax breaks are beneficial? Explain.

43. Tax Breaks Lawmakers write tax breaks into the federal tax code
Don’t need to be approved annually. Remain valid until modified by lawmakers
Costs the government $1.22 trillion > Discretionary spending of $1.11 trillion
The $50K Trick
PlanetMoney, “The Long Run”
2:00 – 6:30

44. Tax Wedge
The difference between the price paid by the buyer and the price received by the seller
Income taxes create a tax wedge, which incentivizes people to work less. Taxes lower potential GDP.
Taxes on consumption (sales taxes) also add to the tax wedge

45. Effect of Income Tax on Labor and Potential GDPW L
GDP
LS + T LS Y1 Y2 W2 W1 LD L2 L1 L2 L1

46. Sticky Prices
The idea that in the short-run, prices (and wages) will not adjust downward.
Keynesians believe that during a recession, unions will fight cuts to nominal wages, which leads to increased unemployment (LS > LD at a given wage)
Additionally, Keynesians believe that because of sticky prices, during a recession, expansionary fiscal policy will have an impact on real GDP, but only a minimal impact on price levels.

47. **Interest Rates**
If the government runs a budget deficit (engages in deficit spending), it funds most of its spending by borrowing money and SELLING bonds.
Selling bonds decreases the money supply and increases the real interest rate, crowding out private investment and thus decreasing AD

48. Monetarist View of Fiscal Policy
Remember, monetarism emphasizes the importance of controlling the money supply to control inflation.
Typically critical of expansionary fiscal policy, arguing it will only cause inflation or crowding out, and therefore not help

49. Supply-Side Effects (Mainstream View)
Def’n: The effects of fiscal policy on potential GDP and the economic growth rate
Occur because the government provides goods and services that increase productivity
Operate more slowly than demand-side effects emphasized by Keynesians
Often ignored during recession because they act too slowly
Considered more effective in the long run

50. Mainstream View
Expansionary fiscal policy causes AD to increase. Government spending ALSO increases productivity by providing goods and services to the public, which causes SRAS to increase.
GDP PL
LRAS
SRAS1
SRAS2
PL2
PL3 =
PL1
AD2
AD1 Y1 Y2 Y3

51. Bias in Fiscal Policy Law-making time lag
Shrinking area of law-maker discretion (increasingly difficult to cut budgets)
Estimating potential GDP (don’t want to create inflation or cause a recession)
Economic Forecasting

52. The Fiscal Ship Go to https://fiscalship.org/ Select three goals
Scan through the various policies and determine how to lower the deficit while also meeting your policy goals.
Record the three policies that have the greatest impact on your budget

53. Research
Research one of the following recessions from US history. What was the unemployment rate? What was GDP when the recession started? What was the interest rate?
Great Depression
April 1960-February 1961
November 1973-March 1975
July 1990-March 1991
Great Recession
What fiscal policies were implemented?
Were the fiscal policies successful in helping ease the effects of the recession? Why or why not?
What were the unemployment rate, level of GDP, and the interest rate after the recession? Is this consistent with the goals of the fiscal policies that were implemented?

54. Trump’s Budget Proposal
Each group is responsible for picking a president to research. What did his federal budget look like? How was money earned and spent?
Record

55. Income Tax = Disincentive to Work?
Read and discuss the article “Do Higher Taxes Make Us Work Less?”
Does an income tax really serve as a disincentive to work?

56. What’s the effect on the federal budget?
What type of fiscal policy should be implemented if you want to decrease the budget deficit?
What type of fiscal policy should be implemented if you want to decrease the budget surplus?