Choice, Change, Challenge, and Opportunity

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FISCAL POLICY
CHAPTER
2
Objectives

• After studying this chapter, you will able to
• Describe the federal budget process and the
  recent history of expenditures, taxes, deficits,
  and debt
• Examine the supply-side effects of fiscal policy
  on employment and potential GDP
• Explain the effects of deficits on saving,
  investment, and economic growth
• Explain how fiscal policy choices redistribute
  benefits and costs across generations
• Explain how fiscal policy can be used to
  stabilize the business cycle

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Balancing Acts on Capitol Hill

• In 2004, the federal government planned collect
  in taxes 17.3 cents of every dollar earned.
• The federal government planned to spend 20 cents
  out of each dollar earned.
• So the government planned a deficit of almost 3
  cents per dollar earned.
• For most of the 1980s and 1990s, the government
  ran deficits, to the extent that the national
  debt is now about 13,000 per person.
• What are the effects of government deficits and
  debt?

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The Federal Budget

• The federal budget is the annual statement of the
  federal governments expenditures and tax
  revenues.
• Fiscal policy is the use of the federal budget to
  achieve macroeconomic objectives, such as full
  employment, sustained long-term economic growth,
  and price level stability.

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The Federal Budget

• The Institutions and Laws
• Fiscal policy is made by the president and
  Congress.
• Figure 15.1 illustrates the timeline.

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The Federal Budget

• Fiscal policy operates within the framework of
  the Employment Act of 1946, which committed the
  government to work toward maximum employment,
  production, and purchasing power.
• The Presidents Council of Economic Advisers
  monitors the economy and advises the President on
  economic policy.

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The Federal Budget

• Highlights of the 2004 Budget
• The projected fiscal 2004 Federal Budget has tax
  revenues of 1,955 billion, expenditures of
  2,256 billion, and a projected deficit of 301
  billion.
• Tax revenues come from personal income taxes,
  social insurance taxes, corporate income taxes,
  and indirect taxes.
• Personal income taxes followed by social
  insurance taxes are the two largest revenue
  sources.

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The Federal Budget

• Expenditures are classified as transfer payments,
  purchases of goods and services, and debt
  interest.
• Transfer payments are by far the largest
  expenditure, and are sources of persistent growth
  in expenditures.

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The Federal Budget

• The federal governments budget balance equals
  tax revenue minus expenditure.
• If tax revenues exceed expenditures, the
  government has a budget surplus.
• If expenditures exceed tax revenues, the
  government has a budget deficit.
• If tax revenues equal expenditures, the
  government has a balanced budget.

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The Federal Budget

• The Budget in Historical Perspective
• Figure 15.2 on the next slide shows the
  governments tax revenues, expenditures, and
  budget surplus or deficit as a percentage of GDP
  for the period 19802004.
• The government had a deficit of 5.2 percent in
  1983.
• The deficit declined and in 1998 to 2001, the
  government had a surplus.
• A deficit arose again in 2002 and 2003.

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The Federal Budget
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The Federal Budget

• Figure 15.3 on the next slide shows the evolution
  of the components of tax revenues and
  expenditures as a percentage of GDP over the
  period 19832003.
• Tax revenues increased and expenditures decreased.

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The Federal Budget
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The Federal Budget

• Government debt is the total amount that the
  government has borrowedthat the government owes.
  It is the accumulation of all past deficits.

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The Federal Budget

• Figure 15.4 shows the evolution of the debt as a
  percentage of GDP since 1942.

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The Federal Budget

• The U.S. Government Budget in Global Perspective
• Figure 15.5 compares government budget deficits
  around the world in 2003.
• The world as a whole that year had a government
  budget deficit of about 3.1 percent of world GDP.

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The Federal Budget

• State and Local Budgets
• In 2002, when the federal government spent 2,000
  billion, state and local governments spent almost
  1,900 billion, mostly on education, protective
  services, and roads.
• State and local budgets are not used for
  stabilization purposes, and occasionally are
  destabilizing in recessions.

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The Supply SideEmployment and Potential GDP

• Fiscal policy has important effects on employment
  and potential GDP called supply-side effects.

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The Supply SideEmployment and Potential GDP

• Full Employment and Potential GDP
• Demand and supply in the labor market determine
  the full employment real wage rate and employment
  level.
• Figure 15.6(a) shows full employment in the labor
  market.

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The Supply SideEmployment and Potential GDP

• The production function along with the level of
  employment at full employment determine potential
  GDP.
• Figure 15.6(b) shows potential GDP when full
  employment is 250 billion labor hours a year.

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The Supply SideEmployment and Potential GDP

• The Effects of the Income Tax
• A tax on labor income influences potential GDP by
  changing the supply of labor and changing full
  employment equilibrium
• Figure 15.6(a) shows the effect of the income tax
  on the labor market.

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The Supply SideEmployment and Potential GDP

• Figure 15.6(b) shows the effects of the income
  tax on potential GDP.
• Full employment decreases to 200 billion labor
  hours a year.
• At this level of employment, potential GDP
  decreases to 10 trillion.

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The Supply SideEmployment and Potential GDP

• The gap between the before-tax wage rate and the
  after-tax wage rate is like a wedge and is called
  the tax wedge.
• Taxes on Expenditure and the Tax Wedge
• Taxes on consumption such as sales taxes add to
  the tax wedge.
• The reason is that a tax on consumption
  expenditure decreases the quantity of goods that
  an hour of labor can buy and is equivalent to an
  income tax.

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The Supply SideEmployment and Potential GDP

• Some Real World Tax Wedges
• Figure 15.7 shows the tax wedges in the United
  States, the United Kingdom, and France.

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The Supply SideEmployment and Potential GDP

• Does the Tax Wedge Matter?
• Potential GDP per person in France is 31 percent
  below that in the United States
• According to research by Edward Prescott, the
  entire difference is explained by the larger tax
  wedge in France.

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The Supply SideEmployment and Potential GDP

• Tax Revenues and the Laffer Curve
• An increase in the tax rate decreases employment.
• If the decrease in employment is large, the total
  amount collected in taxes might decrease when the
  tax rate increases.

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The Supply SideEmployment and Potential GDP

• Figure 15.8 shows the relationship between the
  tax rate and tax revenuescalled the Laffer
  curve.
• In the United States, an increase in the tax rate
  would bring an increase in tax revenue.
• But perhaps not so in France.

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The Supply SideEmployment and Potential GDP

• The Supply-Side Debate
• Supply-siders, economist who believe the
  supply-side effects to be large, first came to
  prominence during the early 1980s and were
  associated with the Reagan administration.
• At that time, they were regarded as extreme and
  branded voodoo economists by the first
  President Bush.
• Today, the supply side is the mainstream.

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The Supply Side Investment, Saving, and Economic
Growth

• The Sources of Investment Finance
• A quick refresher of the national income
  accounting equations is needed.
• GDP C I G X M.
• And
• GDP C S T.
• From these two equations, you can see that
• I S T G M X.

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The Supply Side Investment, Saving, and Economic
Growth

• The equation
• I S T G M X
• says that investment, I, is financed by
• Private domestic saving, S,
• Foreign saving, M X,
• Government saving, T G

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The Supply Side Investment, Saving, and Economic
Growth

• Call saving S plus foreign saving M X private
  saving, PS.
• Then investment is financed by the sum of private
  saving and government saving.
• That is
• I PS T G

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The Supply Side Investment, Saving, and Economic
Growth

• If taxes exceed government purchases, T gt G, the
  government has a budget surplus and government
  saving is positive.
• If taxes are less than government purchases, T lt
  G, the government budget is in deficit and
  government saving is negative.

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The Supply Side Investment, Saving, and Economic
Growth

• Figure 15.9 shows the contributions of the
  sources of investment finance from 1973 through
  2003.
• Foreign sources have become larger.
• The government had a large deficit in 2003.

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The Supply Side Investment, Saving, and Economic
Growth

• Fiscal policy can influence investment in two
  ways
• Taxes affect the incentive to save
• Government savingthe budget surplus or
  deficitis part of total saving

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The Supply Side Investment, Saving, and Economic
Growth

• Taxes and the Incentive to Save
• A tax on interest income drives a wedge between
  the after-tax interest rate earned by savers and
  the before-tax interest rate paid by firms to
  finance investment.
• The effects of a tax on interest income are more
  serious than those on labor income because
• Lower investment slows the growth rate and has a
  cumulative effect on potential GDP
• Inflation makes the effective tax rate on
  interest income high

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The Supply Side Investment, Saving, and Economic
Growth

• Figure 15.10 shows the effects of taxes on the
  incentive to save
• With no taxes, investment is 2 trillion and the
  interest rate is 3 percent a year.

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The Supply Side Investment, Saving, and Economic
Growth

• An income tax drives a wedge between the
  before-tax and after-tax interest rate and
  decreases saving supply.
• Investment decreases to 1.8 trillion and the
  interest rate rises to 4 percent a year.

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The Supply Side Investment, Saving, and Economic
Growth

• Government Saving
• Because government saving is part of total
  saving, the direct effect of a government budget
  deficit is a decrease in total saving.
• When total saving decreases, the real interest
  rate rises and the equilibrium quantity of
  investment decreases.
• The tendency fo a government budget deficit to
  decrease investment is called a crowding-out
  effect.

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The Supply Side Investment, Saving, and Economic
Growth

• Figure 15.11 illustrates the crowding out effect
  of an increase in the government budget deficit.

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The Supply Side Investment, Saving, and Economic
Growth

• A government budget deficit also has an indirect
  effect that offsets the direct effect.
• The Ricardo-Barro effect is an increase in
  private saving by an amount equal to the
  government budget deficit.
• This effect occurs if households recognize that a
  government budget deficit must be paid for by
  higher taxes in the future.

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Generational Effects of Fiscal Policy

• Is a budget deficit a burden on future
  generations?
• What is the full burden of existing government
  programs such as Social Security?
• To answer questions like these, we use a tool
  called generational accounting.
• This accounting system was developed by Alan
  Auerbach and Laurence Kotlikoff.
• Recent generational accounts have been
  constructed by Jagadeesh Gokhale and Kent
  Smetters.

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Generational Effects of Fiscal Policy

• Generational Accounting and Present Value
• Generational accounting calculates the present
  value of taxes and benefits and allocates those
  present values to different generations.
• The Social Security Time Bomb
• As the baby boom generation retires and begins to
  collect is Social Security and Medicare benefits,
  the payout by the federal government on these
  items will be much larger than it is today.
• At the same time, the taxes paid by the baby
  boomers will be lower than they are today.

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Generational Effects of Fiscal Policy

• To assess the federal governments obligations,
  we use the concept of fiscal imbalance, which is
  the present value of the governments commitments
  to pay benefits minus the present value of its
  tax revenues.
• In 2003, fiscal imbalance in the United States is
  estimated to be 45 trillion.

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Generational Effects of Fiscal Policy

• Generational Imbalance
• Generational imbalance is the division of fiscal
  imbalance between the current and future
  generations.
• It is estimated that under existing laws, the
  current generation will pay 43 percent of its own
  benefits.
• Future generations will pick up 57 percent of the
  tab!

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Generational Effects of Fiscal Policy

• Figure 15.12 shows an estimate of the sources of
  fiscal imbalance and its division between the
  current and future generations.

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Generational Effects of Fiscal Policy

• International Debt
• Much of the public debt is held not by the public
  but by foreigners.
• This debt represents a potential drain on
  Americans.
• The scale of this debt in 2003 was about 4
  trillion.
• Foreigners own more than 50 percent of U.S.
  government debt.

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Stabilizing the Business Cycle

• Fiscal policy action that seek to stabilize the
  business cycle work by changing aggregate demand.
• These policy actions can be
• Discretionary
• Automatic
• Discretionary fiscal policy is a policy action
  that is initiated by an act of Congress.
• Automatic fiscal policy is a change in fiscal
  policy triggered by the state of the economy.

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Stabilizing the Business Cycle

• The Government Purchases Multiplier
• The government purchases multiplier is the
  magnification effect of a change in government
  purchases of goods and services on aggregate
  demand.
• A multiplier exists because government purchases
  are a component of aggregate expenditure an
  increase in government purchases increases
  aggregate income, which induces additional
  consumption expenditure.

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Stabilizing the Business Cycle

• The Tax Multiplier
• The tax multiplier is the magnification effect a
  change in taxes on aggregate demand.
• An increase in taxes decreases disposable income,
  which decreases consumption expenditure and
  decreases aggregate expenditure and real GDP.

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Stabilizing the Business Cycle

• The Balanced Budget Multiplier
• The balanced budget multiplier is the
  magnification effect a simultaneous change in
  government purchases and taxes on aggregate
  demand.
• A 1 increase in government purchases increases
  aggregate demand initially by 1 but a 1
  increase in taxes decreases consumption
  expenditure by less than 1 initially, so a 1
  increase in both purchases and taxes increases
  aggregate demand.

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Stabilizing the Business Cycle

• Discretionary Fiscal Stabilization
• In Figure 15.13, an increase in government
  purchases increases aggregate demand.
• A multiplier effect increases aggregate demand
  further.
• Real GDP increases and the price level rises.

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Stabilizing the Business Cycle

• Discretionary Fiscal Stabilization
• In Figure 15.14, a decrease in government
  purchases decreases aggregate demand.
• A multiplier effect decreases aggregate demand
  further.
• Real GDP decreases and the price level falls.

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Stabilizing the Business Cycle

• Limitations of Discretionary Fiscal Policy
• The use of discretionary fiscal policy is
  hampered by three time lags
• Recognition lag
• Law making lag
• Impact lag

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Stabilizing the Business Cycle

• Automatic Stabilizers
• Automatic stabilizers are mechanisms that
  stabilize real GDP without explicit action by the
  government.
• Income taxes and transfer payments are automatic
  stabilizers.
• Because income taxes and transfer payments change
  with the business cycle, the governments budget
  deficit also varies with this cycle.
• In a recession, taxes fall, transfer payments
  rise, and the deficit grows in an expansion,
  taxes rise, transfers fall, and deficit shrinks.

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Stabilizing the Cycle

• Figure 15.15 shows the budget deficit over the
  business cycle for 19812001.
• Recessions are highlighted.

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Stabilizing the Business Cycle

• The structural surplus or deficit is the surplus
  or deficit that would occur if the economy were
  at full employment and real GDP were equal to
  potential GDP.
• The cyclical surplus or deficit is the actual
  surplus or deficit minus the structural surplus
  or deficit that is, it is the surplus or deficit
  that occurs purely because real GDP does not
  equal potential GDP.

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Stabilizing the Business Cycle

• Figure 15.16 illustrates the distinction between
  a structural and cyclical surplus and deficit.
• In part (a), as real GDP fluctuates around
  potential GDP, a cyclical deficit or surplus
  arises.

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Stabilizing the Business Cycle

• In part (b), as potential GDP grows, a structural
  deficit becomes a structural surplus.

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THE END