1. Chapter 12 The Fiscal Policy Approach to Stabilization

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-2 Introduction In the early 2000s the Japanese government sought to cut taxes and increase spending. By early 2004 it launched plans for increasing taxes then in 2005 contemplated cutting them again. In this chapter, you will learn about policy time lags, which contributed to the Japanese government’s on-again, off- again tax policies.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-3 Did You Know That... Since the early 2000s, total government spending has increased at a rate of about 8% per year? This is the largest annual rate of growth since the 1940s and 1950s? There are consequences of higher government spending for equilibrium real GDP and the price level?

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-4 Discretionary Fiscal Policy  The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals is the realm of fiscal policy.  High employment (low unemployment)  Price stability  Economic growth  Improvement of international payments balance

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-5 Discretionary Fiscal Policy (cont'd) Fiscal Policy  The discretionary changing of government expenditures or taxes to achieve national economic goals, such as high employment with price stability

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-6 Discretionary Fiscal Policy (cont'd) An increase in government spending will stimulate economic activity Changes in government spending  Military spending  Education spending  Budgets for government agencies

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-7 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

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-8 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

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-9 Discretionary Fiscal Policy (cont'd) Questions  Would the increase in government spending equal the size of the gap?  What impact would expansionary fiscal policy have on the price level?

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-10 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E 1, where real GDP exceeds long-run equilibrium Contractionary fiscal policy can move aggregate demand to AD 2 via a tax increase A new equilibrium is at E 2 at a lower price level Real GDP is now consistent with LRAS

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-11 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 cut AD 1 moves to AD 2 The economy moves from E 1 to E 2, and real GDP is now at $12 trillion per year We are at the long-run equilibrium level

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-12 Discretionary Fiscal Policy (cont'd) Change in taxes  A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports.

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-13 Discretionary Fiscal Policy (cont'd) Question  What would be the long-run impact of a tax cut on real GDP if the economy is at full- employment equilibrium?

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-14 Possible Offsets to Fiscal Policy Fiscal policy does not operate in a vacuum and important questions must be answered.  How 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?

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-15 Possible Offsets to Fiscal Policy (cont'd) Crowding-Out Effect  The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-16 Figure 13-3 The Crowding-Out Effect, Step by Step

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-17 Figure 13-4 The Crowding-Out Effect Expansionary policy causing deficit spending initially shifts from AD 1 to AD 2 Due to crowding out, AD shifts inward to AD 3 Equilibrium GDP below full-employment GDP—recessionary gap

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-18 Possible Offsets to Fiscal Policy (cont'd) Planning for the future: the Ricardian equivalence theorem  Ricardian Equivalence Theorem  The proposition that an increase in the government budget deficit has no effect on aggregate demand

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-19 Possible Offsets to Fiscal Policy (cont'd) Planning for the future: The Ricardian equivalence theorem  The reason for the offset  People anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly.

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-20 Possible Offsets to Fiscal Policy (cont'd) Direct Expenditure Offsets  Actions on the part of the private sector in spending income that offset government fiscal policy actions  Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset.

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-21 International Policy Example: Britain Pays Up but Receives Little Economic Payoff The United Kingdom makes the third highest net contribution to the EU budget, even though EU expenditures contribute so little to total planned spending in that nation. How do taxes that British residents pay to fund their government’s contribution to the EU budget affect aggregate demand in the United Kingdom?

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-22 Possible Offsets to Fiscal Policy (cont'd) The supply-side effects of changes in taxes  Expansionary fiscal policy could involve reducing marginal tax rates.  Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more.  The increased productivity will lead to more economic growth.

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-23 Possible Offsets to Fiscal Policy (cont'd) Supply-Side Economics  The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-24 Possible Offsets to Fiscal Policy (cont'd) Question  Would a tax increase cause you to work more or less?

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-25 Figure 13-5 Laffer Curve Tax rates and tax revenues rise together Tax revenues are at a maximum Tax rates and tax revenues fall together

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-26 Policy Example: A Laffer Curve in the Mid-2000s? In 2003 Congress reduced the top tax rate on corporate dividends and the tax rate on capital gains along with cutting personal income tax rates slightly. Many critics predicted that the federal government’s tax revenues would plummet after these rates were cut.

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-27 Policy Example: A Laffer Curve in the Mid-2000s? (cont'd) By the middle of 2006, after three years of higher real GDP growth, total federal income tax receipts from corporations and individuals had increased by nearly 40%. Why do you suppose it is difficult to determine exactly which factors are most responsible for the increase?

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-28 Discretionary Fiscal Policy in Practice: Coping with Time Lags Question  Is fiscal policy as precise as it appears?

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-29 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags  Recognition Time Lag  The time required to gather information about the current state of the economy

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-30 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags  Action Time Lag  The time required between recognizing an economic problem and putting policy into effect  Particularly long for fiscal policy which requires congressional approval

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-31 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags  Effect Time Lag  The time it takes for a fiscal policy to affect the economy

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-32 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Fiscal policy time lags are long and a policy designed to correct a recession may not produce results until the economy is experiencing inflation. Fiscal policy time lags are variable in length (1–3 years), and the timing of the desired effect cannot be predicted.

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-33 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-34 Automatic Stabilizers Automatic or Built-In Stabilizers  Changes in government spending and taxation that occur automatically without deliberate action of Congress  The tax system  Unemployment compensation  Welfare spending

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-35 Figure 13-6 Automatic Stabilizers The automatic changes tend to drive the economy back toward its full- employment output level

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-36 What Do We Really Know About Fiscal Policy? Fiscal policy during normal times  Congress ends up doing too little too late to help in a minor recession.  Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty.

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-37 What Do We Really Know About Fiscal Policy? (cont'd) Fiscal policy during abnormal times  Fiscal policy can be effective  The Great Depression—fiscal policy may be able to stimulate aggregate demand.  Wartime—during World War II real GDP increased dramatically.

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-38 What Do We Really Know About Fiscal Policy? (cont'd) The “soothing” effect of Keynesian fiscal policy  Should we encounter a severe downturn, fiscal policy is available.  Knowing this may reassure consumers and investors.  Stable expectations encourage a smoothing of investment spending.

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-39 Issues and Applications: The Roller Coaster of Japanese Tax Policy Between 2000 and 2002, the average rate of growth in total expenditures on goods and services in Japan was 0%. In an effort to boost aggregate demand amid a slumping economy the Japanese government cut taxes to spur growth. By the end of 2004 the Japanese government found it was spending nearly twice as much as it was receiving in tax revenues, financing the rest by borrowing.

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-40 Figure 13-7 Government Spending and Tax Revenues in Japan

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-41 Issues and Applications: The Roller Coaster of Japanese Tax Policy (cont'd) Recognition lag  The period between 2003 when aggregate demand began to pick up and 2004 when the government recognized it is called a recognition lag. Action lag  In 2004 the government began a plan to phase in tax increases between 2005 and 2007.

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-42 Issues and Applications: The Roller Coaster of Japanese Tax Policy (cont'd) The roller coaster ride continues  In 2005, the Japanese government gradually phased in the first scheduled tax increase.  Spending fell and new information showed total expenditures had increased at a rate of less than 1% in 2005.

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-43 Issues and Applications: The Roller Coaster of Japanese Tax Policy (cont'd) The roller coaster ride continues  Tax increases slated for 2006 and 2007 threatened to reduce aggregate demand even further.  During 2006 the Japanese government began rethinking its policy options once more and the cycle began anew.

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-44 Introduction In adopting the euro, European nations agreed to abide by the Stability and Growth Pact. The pact called for limitations on government spending over tax collections to be no more than 3% of GDP—yet many European governments have since changed their tune.

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-45 Did You Know That... Throughout the rest of this decade, the U.S. federal government expects to run annual budget deficits? The relationship between budget deficits and macroeconomic performance is somewhat elusive?

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-46 Public Deficits and Debts: Flows versus Stocks Government Budget Deficit  Exists if the government spends more than it receives in taxes during a given period of time  Is financed by the selling of government securities (bonds)

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-47 Public Deficits and Debts: Flows versus Stocks (cont'd) The federal deficit is a flow variable, one defined for a specific period of time, usually one year.

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-48 Public Deficits and Debts: Flows versus Stocks (cont'd) If spending equals receipts, the budget is balanced. If receipts exceed spending, the government is running a budget surplus.

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-49 Public Deficits and Debts: Flows versus Stocks (cont'd) Balanced Budget  A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time

50. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-50 Public Deficits and Debts: Flows versus Stocks (cont'd) Government Budget Surplus  An excess of government revenues over government spending during a given period of time

51. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-51 Public Deficits and Debts: Flows versus Stocks (cont'd) Public Debt  A stock variable  The total value of all outstanding government securities

52. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-52 Government Finance: Spending More than Tax Collections Since 1940, the U.S. federal government has operated with a budget surplus in 13 years. In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.

53. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-53 Figure 14-1 Federal Budget Deficits and Surpluses Since 1940

54. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-54 Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP

55. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-55 Government Finance: Spending More than Tax Collections (cont'd) The resurgence of federal government deficits Question  Why has the government’s budget recently slipped from a surplus of 2.5% of GDP into a deficit?

56. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-56 Policy Example: Explaining a $109 Billion Deficit Projection Turnaround Why was the government’s 2005 deficit projection off by $109 billion? Federal tax revenues turned out to be more than 15% higher in 2005. Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated.

57. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-57 Evaluating the Rising Public Debt Gross Public Debt  All federal government debt irrespective of who owns it Net Public Debt  Gross public debt minus all government interagency borrowing

58. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-58 Evaluating the Rising Public Debt (cont'd) Some government bonds are held by government agencies.  In this case, the funds are owed from one branch of the federal government to another.  To arrive at the net public debt, we subtract interagency borrowings from the gross public debt.

59. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-59 Evaluating the Rising Public Debt (cont'd) Tax revenues tend to be stagnant during times of slow economic growth. Tax revenues grow more quickly when overall growth enhances incomes. As long as spending exceeds revenues, the budget deficit will persist.

60. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-60 Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It

61. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-61 Figure 14-3 Net U.S. Public Debt as a Percentage of GDP

62. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-62 Net U.S. Public Debt as a Percentage of GDP During World War II, the net public debt grew dramatically. After the war  It fell until the 1970s  Started rising in the 1980s  Declined once more in the 1990s  And recently has been increasing again

63. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-63 Evaluating the Rising Public Debt (cont'd) The government must pay interest on the public debt outstanding. The level of these payments depends on the market interest rate. Interest payments as a percentage of GDP are likely to rise in the future.

64. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-64 Evaluating the Rising Public Debt (cont'd) As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases. Foreign residents, businesses and governments hold nearly 50% of the net public debt. Thus, we do not owe the debt just to ourselves.

65. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-65 Evaluating the Rising Public Debt (cont'd) If the economy is already at full employment, then further provision of government goods will crowd out some private goods. Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector.

66. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-66 Evaluating the Rising Public Debt (cont'd) Crowding-out may place a burden on future generations.  Increased present consumption may crowd out investment and reduce the growth of capital goods—which could reduce a future generation’s wealth.  Taxes may have to be increased; imposing higher taxes on future generations in order to retire the debt.

67. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-67 Evaluating the Rising Public Debt (cont'd) Paying off the public debt in the future  If the debt becomes larger, each person’s share would increase.  Taxes would be levied, and may not be assessed equally.  A special tax could be levied based on a person’s ability to pay.

68. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-68 Evaluating the Rising Public Debt (cont'd) Our debt to foreign residents  We do not owe all the debt to ourselves.  Future U.S. residents will be taxed to repay principal and interest.  Portions of U.S. incomes will be transferred abroad.

69. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-69 Evaluating the Rising Public Debt (cont'd) If deficits lead to slower growth rates future generations will be poorer. Both present and future generations will be economically better off if…  Government expenditures are really investments  The rate of return on such public investments exceeds the interest rate paid on the bonds

70. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-70 International Example: Where Are Most Treasury Securities Held Abroad? More than $2 trillion in U.S. Treasury securities of the $5 trillion in net outstanding debt is held outside the United States. Japan accounts for more than one-third of all foreign holdings of the U.S. net public debt.

71. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-71 Figure 14-4 The Distribution of Foreign Holdings of U.S. Treasury Securities

72. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-72 International Example: Where Are Most Treasury Securities Held Abroad? (cont'd) For critical analysis:  Why might the fact that market interest rates in Japan have hovered very close to 0% during the 2000s help explain relatively large holdings of U.S. Treasury securities by residents of that country?

73. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-73 Federal Budget Deficits in an Open Economy Question  Is there a connection between the U.S. trade deficit and the federal government budget deficit?

74. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-74 Federal Budget Deficits in an Open Economy (cont'd) We know what a budget deficit is, but a trade deficit exists when the value of imports exceeds the value of exports. Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two.

75. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-75 Figure 14-5 The Related U.S. Deficits

76. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-76 Federal Budget Deficits in an Open Economy (cont'd) As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners. The interest rate paid on bonds will need to be high enough to attract foreign investors.

77. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-77 Federal Budget Deficits in an Open Economy (cont'd) If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports. This shows that a U.S. budget deficit can contribute to a trade deficit.

78. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-78 Growing U.S. Government Deficits: Implications for U.S. Economic Performance Which government deficit is the true deficit?  The government may report distorted measures of its own budget.  Government has not adopted a business-like approach to tracking its expenditures and receipts.  Official government “measures” yield lowest possible deficits and highest reported surpluses.

79. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-79 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) An operating budget includes current outlays for on-going expenses, such as salaries and interest payments. A capital budget, includes expenditures on investment items, such as machines, buildings, roads, and dams.

80. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-80 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Capital budgeting theory  For years, many economists have recommended Congress create a capital budget and remove investment outlays from the operating budget.  Opponents point out this would allow the government to grow even faster than at present.

81. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-81 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure.

82. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-82 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Pick a deficit, any deficit: deficit estimates are produced both by  The Office of Management and Budget  The Congressional Budget Office They have different names  “Baseline deficit”  “Policy deficit”  “On-budget deficit”

83. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-83 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) There is also some disagreement as to whether the Social Security surplus should be used to reduce current deficit numbers. So keep in mind that any one specific deficit measure you hear is based on a definition and a set of assumptions with which others may disagree.

84. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-84 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Question  How do higher deficits affect the economy in the short run? Answers  If the economy is below full-employment, the deficit can close the recessionary gap.  If the economy is already at full-employment, the deficit can create an inflationary gap.

85. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-85 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) In the long run, higher government budget deficits have no effect on equilibrium real GDP. Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services.

86. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-86 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Thus, if the government operates with higher deficits over an extended period  The ultimate result is a shrinkage in the share of privately produced goods and services  By continually spending more than it collects, the government takes up a larger portion of economic activity.

87. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-87 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) How could the government reduce all its red ink?  Increasing taxes for everyone  Taxing only the rich  Reducing expenditures  Whittling away at entitlements

88. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-88 Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase Many have proposed raising taxes on the highest-income earners. Just like everyone else high-income individuals respond to incentives. The richest tax payers could use deferred compensation plans. These individuals would shift income earned in current years to future years.

89. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-89 Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase (cont'd) Government estimates show increasing the top bracket from 35% to 39.6% would reduce total taxable income by at least 4%. Projections show the increase would give the highest income taxpayers a greater incentive to incorporate and pay lower corporate-profit tax rates.

90. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-90 Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase (cont'd) Thus, raising the income tax rate by 4.6 percentage points would result in less than a 4.6% increase in government tax collections.

91. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-91 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) In considering how expenditures might be reduced, it is important to look at entitlements. These are federal government payments that are legislated obligations and cannot be reduced or eliminated.

92. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-92 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Entitlements  Guaranteed benefits under a government program such as Social Security, Medicare, or Medicaid Noncontrollable Expenditures  Government spending that changes automatically without action by Congress

93. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-93 Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending

94. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-94 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Entitlements are the largest component of the U.S. federal budget. To make a significant cut in expenditures, entitlement programs would have to be revised.

95. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-95 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Question  What are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid?

96. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-96 Issues and Applications: Budget Deficit Rules Made to Be Broken? Under the Stability and Growth Pact each EU member nation agreed on net public debt and annual budget deficit percentages. Net public debt as a percentage of GDP should be no higher than 60%, with the annual budget deficit no higher than 3% of GDP.

97. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-97 Issues and Applications: Budget Deficit Rules Made to Be Broken? (cont'd) All EU nations satisfied the 60% constraint on net public debt as a proportion of GDP. Several EU countries failed to satisfy the 3% limitation on the ratio of the budget deficit to GDP.

98. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-98 Issues and Applications: Budget Deficit Rules Made to Be Broken? (cont'd) During the 2000s, many nations were experiencing deficits in excess of 3% of GDP as economies slowed, entitlements grew, and tax revenues were stagnant. Several governments that violated the 3% limit did so hoping expansionary fiscal policies would boost aggregate demand and prevent recessions.

99. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 12-99 Key Terms and Concepts automatic stabilizers budget surpluses consumption crowding out effect disposable income fiscal policy Investment Keynesian economics marginal propensity to consume (MPC) marginal propensity to save (MPS) multiplier effect saving