2 IntroductionWhen U.S. economic activity began to weaken in early 2008, the U.S. government gave lower- and middle- income households one-time payments called tax rebates.During the depths of the Great Recession in 2009, the government authorized another round of tax rebates.Why and how does the U.S. government sometimes seek to influence economic activity by varying expenditures and tax receipts?Reading this chapter will help you answer this questions.
3 Learning ObjectivesUse traditional Keynesian analysis to evaluate the effects of discretionary fiscal policyDiscuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actionsExplain why the Ricardian equivalence theorem calls into question the usefulness of tax changes
4 Learning Objectives (cont'd) List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal “fine tuning”Describe how certain aspects of fiscal policy function as automatic stabilizers for the country
5 Chapter Outline Discretionary Fiscal Policy Possible Offsets to Fiscal PolicyDiscretionary Fiscal Policy in Practice: Coping with Time LagsAutomatic StabilizersWhat Do We Really Know About Fiscal Policy?
6 Did You Know That ...A massive fiscal stimulus package approved by the U.S. Congress in early 2009 allocated nearly $600 billion directly to state governments during 2009 and 2010?In this chapter, you will learn about how variations in government spending and taxes affect real GDP and the price level.
7 Discretionary Fiscal Policy The discretionary changing of government expenditures or taxes in order to achieve national economic goals, such as:High employment (low unemployment)Price stabilityEconomic growth
8 Discretionary Fiscal Policy (cont'd) An increase in government spending will stimulate economic activityChanges in government spending:Military spendingEducation spendingBudgets for government agencies
9 Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a) If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand
10 Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b) If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand
11 Discretionary Fiscal Policy (cont'd) QuestionsWould the increase in government spending equal the size of the gap?What impact would expansionary fiscal policy have on the price level?
12 Why Not … end our economic troubles by borrowing to finance additional discretionary government spending?Almost all of the federal government’s revenues go toward funding nondiscretionary programs such as Social Security, Medicare, and Medicaid.Thus, since 2009, on average, the federal government has had to borrow more than 90 cents of every single dollar that it has committed to discretionary spending intended to stimulate economic activity.12
13 Discretionary Fiscal Policy (cont'd) Change in taxesA rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports
14 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibriumContractionary fiscal policy can move aggregate demand to AD2 via a tax increaseA new equilibrium is at E2 at a lower price levelReal GDP is now consistent with LRAS
15 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b) In panel (b) with a recessionary gap (in this case $500 billion) taxes are cutAD1 moves to AD2The economy moves from E1 to E2, and real GDP is now at $12 trillion per yearWe are at the long-run equilibrium level
16 Discretionary Fiscal Policy (cont'd) QuestionWhat would be the long-run impact of a tax cut on real GDP if the economy is at full-employment equilibrium?
17 Possible Offsets to Fiscal Policy Fiscal policy does not operate in a vacuum and important questions must be answeredHow are expenditures financed and by whom?If taxes are increased what does government do with the taxes?What will happen if individuals worry about increases in future taxes?
18 Possible Offsets to Fiscal Policy (cont'd) Crowding-out effectThe tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sectorThis decrease normally results from the rise of interest rates
19 Figure 13-3 The Crowding-Out Effect, Step by Step
20 Figure 13-4 The Crowding-Out Effect Due to crowding out, AD shifts inward to AD3
21 Possible Offsets to Fiscal Policy (cont'd) Ricardian Equivalence TheoremThe proposition that an increase in the government budget deficit has no effect on aggregate demandReason: people anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly
22 Possible Offsets to Fiscal Policy (cont'd) Direct Expenditure OffsetsActions on the part of the private sector in spending income that offset government fiscal policy actionsAny increase in government spending in an area that competes with the private sector will have some direct expenditure offset
23 Possible Offsets to Fiscal Policy (cont'd) The supply-side effects of changes in taxesExpansionary fiscal policy could involve reducing marginal tax ratesAdvocates argue this increases productivity since individuals will work harder and longer, save more, and invest moreThe increased productivity will lead to more economic growth
24 Possible Offsets to Fiscal Policy (cont'd) Supply-side effects of changes in taxesLower tax rates lead to an increase in productivity because individuals will work harder and longer, save more, and invest moreIncreased productivity will in turn lead to more economic growth, thus higher real GDPResults: Lower marginal tax rates will not necessarily reduce tax revenues due to a larger tax base
26 Policy Example: Which Affects Real GDP More—Spending or Tax Cuts? Several economists have found that discretionary increases in government spending have significantly smaller effects on real GDP than do discretionary tax cuts:Each $1 in real government purchases generates a net increase in real GDP of only about $0.70Each $1 tax cut brings about an increase in real GDP somewhere between $1.40 and $3.0026
27 Discretionary Fiscal Policy in Practice: Coping with Time Lags QuestionIs the conduct of fiscal policy as precise as it appears?AnswerThe difficulty is that the conduct of fiscal policy involves a variety of lags.
28 Time lags Recognition Time Lag Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)Time lagsRecognition Time LagThe time required to gather information about the current state of the economy
29 Time lags Action Time Lag Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)Time lagsAction Time LagThe time required between recognizing an economic problem and putting policy into effectParticularly long for fiscal policy which requires congressional approval
30 Time lags Effect Time Lag Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)Time lagsEffect Time LagThe time it takes for a fiscal policy to affect the economy
31 Fiscal policy time lags are: Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)Fiscal policy time lags are:Long – a policy designed to correct a recession may not produce results until the economy is experiencing inflationVariable in length – they can be from 1-3 years, and the timing of the desired effect cannot be predictedBecause fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy
32 Automatic Stabilizers Automatic or Built-In StabilizersChanges in government spending and taxation that occur automatically without deliberate action of CongressThe tax systemUnemployment compensationWelfare spending
33 Automatic Stabilizers (cont’d) The Tax SystemIncomes and profits fall when business activity slows down, and the government’s tax revenues drop as wellSome economists consider this an automatic tax cut, which therefore stimulates aggregate demand
34 Automatic Stabilizers (cont’d) Unemployment Compensation and Income Transfer PaymentsUnemployment compensation reduces changes in people’s disposable income. Their disposable income remains positive, although at a lower levelIn a recession, more people are eligible for income transfer payments and do not experience as dramatic a drop in disposable income
35 Automatic Stabilizers (cont’d) Stabilizing ImpactThe key impact of these systems is the ability to mitigate changes in disposable income, consumption, and the equilibrium level of GDPIf disposable income is prevented from falling as much as it otherwise would in a recession, the downturn will be moderated
36 Figure 13-6 Automatic Stabilizers The automatic changes tend to drive the economy back toward its full-employment output level
37 What Do We Really Know About Fiscal Policy? Fiscal policy during normal timesCongress ends up doing too little too late to help in a minor recessionFiscal policy that generates repeated tax changes (as has happened) creates uncertainty
38 What Do We Really Know About Fiscal Policy? (cont'd) Fiscal policy during abnormal timesFiscal policy can be effectiveThe Great Depression—fiscal policy may be able to stimulate aggregate demandWartime—during World War II real GDP increased dramatically
39 What Do We Really Know About Fiscal Policy? (cont'd) The “soothing” effect of Keynesian fiscal policyShould we encounter a severe downturn, fiscal policy is availableKnowing this may reassure consumers and investorsStable expectations encourage a smoothing of investment spending
40 You Are There: Raising Tax Rates While Emerging from a Severe Recession In 2010, White House Budget Director Peter Orszag anticipated that the government’s tax revenues would fall short of its spending every year for the rest of the 2010s.Orszag also viewed that the only way to bring revenues and spending back into closer balance was to raise federal tax rates.He hoped that increased annual government spending would stimulate the economy sufficiently to make up for the contractionary effects of these higher tax rates.
41 Issues & Applications: Temporary Tax Rebates Prove to Be Nonstimulating Figure 13-7 shows that real disposable income rose after the one-time tax rebates in 2008 and 2009 but real consumption expenditure did not.41
42 Figure U.S. Real Disposable Personal Income and Real Personal Consumption Expenditures since January 200742
43 Possible explanations: Issues & Applications: Temporary Tax Rebates Prove to Be Nonstimulating (cont’d)Possible explanations:Many people who received the rebates used them to pay off debts instead of spending the funds on goods and servicesThe government financed the rebates by borrowing, so a number of households responded by saving them (the Ricardian equivalence theorem)The tax rebates were temporary lump sums, not permanent reductions in income tax rates (supply-side economics)43
44 Summary Discussion of Learning Objectives The effects of discretionary fiscal policy using traditional Keynesian analysisIncreases in government spending and decreases in taxes increase aggregate demandDecreases in government spending and increases in taxes decrease aggregate demand
45 Summary Discussion of Learning Objectives (cont'd) How indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actionsDeficits increase interest ratesSome government spending replaces private spendingIf the Ricardian equivalence theorem is valid, a tax cut has no effect on total planned expenditures and aggregate demand
46 Summary Discussion of Learning Objectives (cont'd) Fiscal policy time lags and the effectiveness of fiscal “fine tuning”The time lags for fiscal policy are the recognition time lag, action time lag, and the effect time lagThe time lags are long and variableAutomatic stabilizers are changes in tax payments, unemployment compensation, and welfare payments that automatically change with the level of economic activity
47 Appendix D: Fiscal Policy: A Keynesian Perspective The traditional Keynesian approach to fiscal policy differs in three ways from that presented in Chapter 13:It emphasizes the underpinnings of the components of aggregate demandIt assumes that government expenditures are not substitutes for private expenditures and that current taxes are the only taxes taken into account by consumers and firmsIt focuses on the short run and so assumes that as a first approximation, the price level is constant47
48 Figure D-1 The Impact of Higher Government Spending on Aggregate Demand
49 Figure D-2 The Impact of Higher Taxes on Aggregate Demand
50 Appendix D: The Balanced-Budget Multiplier Balanced-budget increase in real spendingThe government increases spending by $1 and pays for it by raising current taxes by $1Balanced-budget multiplier is equal to 150