Fiscal Policy

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Fiscal Policy

• Keynesian view
• Discretionary versus non-discretionary fiscal
  policy
• The automatic stabilizers
• Fiscal policy to close a contractionary gap.
• Fiscal policy to close an expansionary gap.
• Problems with fiscal policy
• Principles of taxation
• The Federal Deficit and the National Debt

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Fiscal Policy
The use of the taxing and spending powers of
government to regulate aggregate expenditure, and
thereby to stabilize the economy
The economy needs to be stabilized. The economy
can be stabilized. The economy should be
stabilized. This is the Keynesian view
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Employment Act of 1946
This legislation established a responsibility for
the federal government to promote maximum
employment, production, and purchasing power.
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Discretionary versusnon-discretionary spending
Discretionary fiscal policy is the deliberate
manipulation of government purchases, taxation,
and transfer payments to pursue macroeconomic
goals such as full employment and price stability.
The Bush tax stimulus package of 2008 and the
Obama stimulus package of 2009 are examples of
discretionary fiscal policy
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Automatic stabilizers
Non-discretionary or built-in features of
government spending and taxation that reduce
fluctuations in disposable income, and thus
consumption, over the business cycle.

• Tax rates for various types of income are set by
  elected officials. Tax collections depend on the
  employment levels/incomes, profits, capital
  gains, retails sales, . . .
• Elected officials establish eligibility
  requirements and support levels for needs-tested
  transfer paymentse.g., TANF, food stamps, and
  unemployment compensation. Actual government
  outlays for needs-tested transfer payments depend
  on (1) the number of persons eligible and (2)
  the number of those eligible that actually file
  claims.

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As the economy enters a recession, federal
revenues tend to decline while at the same time
transfer payments rise. Thus recession brings
about an automatic decline of net taxes (NT)
Remember that DI Y - NT
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How the Automatic Stabilizers Work
G, T
Potential GDP
T TX - TR
G
Deficit
Balanced budget at full-employment
0
Y1
Real GDP
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Keynesian Rx
If a lack of aggregate expenditure is the
problem, why not use the spending and taxing
powers of the federal government to stimulate
aggregate expenditure
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How Fiscal Policy Works
AE
AE2
AE1
?G
Full employment GDP
Real GDP
0
Y1
YFE
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The preceding slide illustrates the type of
expansionary fiscal policy that Keynesians
recommend for recession. We will now use the
AS-AD framework to illustrate contractionary
fiscal policy.
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Modeling Contractionary Fiscal Policy
Price Level
Potential GDP
AS
AD2
AD1
0
Y1
Real GDP
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Using expansionary fiscal policyto close a
contractionary gap
YF is full-employment (potential) GDP.
AE
AE
AE

• Increase in G
• Decrease in NT

Y
YF
Real GDP (Y)
Contractionary gap
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Problems with (discretionary) fiscal policy

1. Policy lags
2. Permanent income

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Principles of Taxation

• Horizontal equity Tax code should be written so
  that those in the same economic circumstances pay
  the same amount in taxes.
• Vertical equity Tax code should be written so
  that those in different economic circumstances
  should pay an unequal amount in taxes.
• Benefits received principle Those who derive
  more benefits from government programs should pay
  more taxes.

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Definitions

• Taxable income Gross income - income exempt from
  taxes. Example For single filers who use the
  1040EZ

• Average tax rate (ATR) Tax payments as a percent
  of taxable income.
• Marginal tax rate (MTR) The tax rate applied to
  the last dollar of taxable income.

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Definitions, continued

• Progressive tax The proportion of taxable income
  taken in taxes increases as taxable income
  increases.
• Regressive tax The proportion of taxable income
  taken in taxes decreases as taxable income
  increases.
• Proportional tax The proportion of taxable
  income taken in taxes remains constant as
  taxable income increases.

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Affluent
Needy
The tax code is a tool for income redistribution
By making the tax structure progressive,
governments can make the after-tax distribution
of income more equitable (or even).
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Federal personal Income Tax rates Under the 1993
Tax Reform Act (Married couple filing jointly)
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Average and Marginal Tax Rates under the Tax
Reform Act of 1993 (for a couple with 2 children)
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Tax Brackets for 2003 under the 2001 Tax Reform
Act
2003 Taxable Income Marginal Tax Rate
0-12,000 10.0
12,000-47,500 15.0
47,500-114,650 27.0
114,650-174,700 30.0
174,700-311,950 35.0
Over 311,950 38.6
Source Wall Street Journal
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Quick Facts about President Bushs Tax Bill

• The 39.6 tax rate reduced to 33
• The 36 tax rate reduced to 33
• The 31 rate reduced to 25
• The 28 rate reduced to 25
• The current 15 bracket is retained over most of
  its range
• A new 10 bracket applies to the lowest ¼ of 15
  range.
• Maximum rate on capital gains reduced from 28 to
  15 percent.

President Bush comments (wav)
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Fun Fact Of the 477 billion in federal tax cuts
over 10 years, 52 percent go to the top 1 percent
of households (average income 343,000).
Source Center for Tax Justice
The Bush tax cuts are scheduled to expire in
2010. Senator McCain favors renewing themeven
though he voted against the Bush tax bill in
2001. Senators Clinton and Obama support raising
marginal rates on capital gains and also for high
income families.
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Why a sales tax is regressive
Assume a 7.13 percent excise tax on groceries,
gasoline, cigarettes, and liquor
Family (1)Income (2)Spending for items subject to excise tax (3) (2)/(1) (4) Excise Tax Paid (5)(4)/(1)ATR
Greens 27,000 16,200 .60 1,188 4.4
Jones 64,000 25,600 .40 1,871 2.9
Lemons 270,000 40,500 .15 2,961 1.0
Moral of the story Low income families tend to
spend a greater proportion of their income on
items subject to excise taxes. Hence excise taxes
tend to be regressive.
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The Arkansas state sales tax on groceries was
reduced from 6 percent to 3 percent effective
July 1, 2007
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In the case of a federal deficit, the Treasury
must borrow. The national debt is the accumulated
borrowing of the federal government in all
previous fiscal years, minus what has been repaid
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For updated information, check the National Debt
Clock
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Is a large national debt a bad thing?

• Arguments against a large national debt include
• The burden on future generations argument.
• A large national debt means that a significant
  share of federal spending must be allocated for
  interest paymentsleaving less for other
  priorities.
• A large national debt makes the U.S. too
  dependent on foreign financial inflows.
• Federal borrowing crowds out private sector
  borrowing unitsi.e., firms and households.

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We (the U.S.) owe 5.7 trillion in debt
and if we dont pay it off, our children and our
grandchildren are going to have to.
Congressman Marion Berry, in a speech to the
Jonesboro Lions Club on April 16, 2001.
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Interest payments as a Percent of Federal
Expenditures (Annual)
www.economagic.com
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Hall Liberman Rule-of-Thumb
As long as the debt grows by the same
percentage as nominal GDP, the ratios of debt to
GDP will remain constant. In this case, the
government can continue to pay interest on its
rising debt without increasing the average tax
rate in the economy.
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Click image below to enlarge.

National Debt Graph (2007 Budget data)  
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