1. F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez Fiscal Policy

2. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 2 of 21 THE ROLE OF FISCAL POLICY 15.1 fiscal policy Changes in government taxes and spending that affect the level of GDP.

3. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 3 of 21 THE ROLE OF FISCAL POLICY 15.1 Fiscal Policy and Aggregate Demand ▼ FIGURE 15.1 Fiscal Policy in Action

4. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 4 of 21 THE ROLE OF FISCAL POLICY 15.1 Fiscal Policy and Aggregate Demand expansionary policies Government policy actions that lead to increases in aggregate demand. contractionary policies Government policy actions that lead to decreases in aggregate demand.

5. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 5 of 21 THE ROLE OF FISCAL POLICY 15.1 The Fiscal Multiplier The Limits to Stabilization Policy stabilization policies Policy actions taken to move the economy closer to full employment or potential output.  FIGURE 15.2 Possible Pitfalls in Stabilization Policy LAGS

6. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 6 of 21 THE ROLE OF FISCAL POLICY 15.1 The Limits to Stabilization Policy inside lags The time it takes to formulate a policy. outside lags The time it takes for the policy to actually work. LAGS FORECASTING UNCERTAINTIES

7. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 7 of 21 THE FEDERAL BUDGET 15.2 Federal Spending discretionary spending The spending programs that Congress authorizes on an annual basis. entitlement and mandatory spending Spending that Congress has authorized by prior law, primarily providing support for individuals.

8. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 8 of 21 THE FEDERAL BUDGET 15.2 Federal Spending Social Security A federal government program to provide retirement support and a host of other benefits. Medicare A federal government health program for the elderly. Medicaid A federal and state government health program for the poor.

9. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 9 of 21 INCREASING LIFE EXPECTANCY AND AGING POPULATIONS SPUR COSTS OF ENTITLEMENT PROGRAMS APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing costs for their government programs? Today, Social Security, Medicare, and Medicaid constitute approximately 9 percent of GDP. Experts estimate that in 2075 spending on these programs will be approximately 21 percent of GDP. How will our society cope with increased demands for these services? Possible solutions: Leave the existing programs in place and just raise taxes to pay for them. The government should save and invest now to increase GDP in the future to reduce the burden on future generations. Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being. Reform the health-care system to encourage more competition to reduce health- care expenditures.

10. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 10 of 21 THE FEDERAL BUDGET 15.2 Federal Revenues SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE supply-side economics A school of thought that emphasizes the role that taxes play in the supply of output in the economy. Laffer curve A relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged.

11. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 11 of 21 MOST AMERICANS FIND TAX SYSTEM UNFAIR The poll results show that most people also believe the poor bear a larger tax burden than they should. All of this information comes at a time when the current Bush administration is attempting to make tax cuts for wealthier individuals, and also businesses, permanent. Fifty-eight percent of the American public believes the current U.S. income tax system is unfair. The general consensus is that middle class individuals and small businesses pay too much in taxes and that the wealthy and big businesses pay too little in taxes. The overall opinion remains largely the same as it was two decades ago in spite of numerous changes to the tax code. Extra Application 4 The Laffer curve shows the proposed relationship between the tax rate expressed as a percentage and the total tax revenues such percentages should generate. Tax revenues are maximized at some rate T and begin to fall at higher tax rates. If the Laffer curve is correct, total tax revenues may fall if the tax rate gets too high because high tax rates create disincentive to earn more money. Why work if the government gets all your income in taxes?

12. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 12 of 21 THE FEDERAL BUDGET 15.2 The Federal Deficit and Fiscal Policy budget deficit The amount by which government spending exceeds revenues in a given year. budget surplus The amount by which government revenues exceed government expenditures in a given year.

13. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 13 of 21 HOW GOVERNMENTS USE BUDGET BASELINES TO FORECAST DEFICITS APPLYING THE CONCEPTS #2: How does the U.S. government make short- and long-term budget projections? When Congress and the president consider the proper course of fiscal policy, they want to consider the future state of the budget. Will there be a deficit or surplus and how big will the deficit or surplus be? To make these forecasts, it is necessary to make budget baselines-explicit assumptions about what spending and tax policies will be in place. For long-term forecasts the Congressional Budget Office (CBO) assumes: Mandatory spending will continue as required by law. Discretionary spending will remain constant in real terms. For taxes, the CBO also makes its estimates based on current law: Even if most political observers believe that Congress will not let important tax provisions expire, CBO is required to assume so in its budget baseline. CBO might project a balanced budget, but in reality Congress might reestablish the tax cut, with a resulting budget deficit.

14. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 14 of 21 THE FEDERAL BUDGET 15.2 Automatic Stabilizers automatic stabilizers Taxes and transfer payments that stabilize GDP without requiring policy makers to take explicit action. The increased federal budget deficit works through three channels: 1 Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income. 2 Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much. 3 Because the corporation tax depends on corporate profits and profits fall in a recession, taxes also fall on businesses. Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession.

15. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 15 of 21 THE FEDERAL BUDGET 15.2 Are Deficits Bad?  Deficits financed by borrowing create debt that competes with corporate debt and borrowing. This results in higher interest rates, crowding out private investment demand. (G rises, but I falls.)  Government borrowing requires the government to make interest payments, which become part of future budgets, contributing to future deficits.  Deficits financed by money creation (by the Fed) ultimately results in inflation. Eventually, the Fed will have to combat this inflation by reducing the money supply growth, slowing the economy.  Government borrowing and money creation both have an impact on exchange rates, affecting the trade balance (NX, net exports).

16. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 16 of 21 FISCAL POLICY IN U.S. HISTORY 15.3 The Depression Era The Kennedy Administration The Vietnam War Era permanent income An estimate of a household’s long-run average level of income. The Reagan Administration

17. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 17 of 21 SURVEYS SHOW MUCH OF THE 2001 TAX CUTS WERE SAVED APPLYING THE CONCEPTS #3: How much did the 2001 tax cuts stimulate consumer spending? According to conventional economic theory, a permanent cut in taxes should largely be spent by households because it represents a new permanent source of income for them. In 2001, approximately 90 million U.S. households received tax rebate checks from the government. To discover whether in practice households actually spent the tax cuts, a nationally representative set of households were asked whether they were more likely to spend the rebate or save it. Result: Less than 25 percent of households were likely to spend the rebate. Reasons: Many households did not believe that they would receive future rebates of a similar size. The large fall in the stock market in the two previous years may have made households more financially tentative and inclined to save.

18. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 18 of 21 FISCAL POLICY IN U.S. HISTORY 15.3 The Clinton and George W. Bush Administrations  FIGURE 15.3 Federal Taxes, Spending, and Deficits, 1996–2005