Parkin-Bade Chapter 24

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CHAPTER
Fiscal Policy
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After studying this chapter you will be able to

• Describe the federal budget process and the
  recent history of outlays, tax revenues,
  deficits, and debts
• Explain the The Supply-Side Employment and
  Potential GDP on employment and potential GDP
• Explain the effects of deficits on investment,
  saving, 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 2007, the federal government planned to spend
  21.1 cents out of each dollar earned in the
  United States and collected 18.2 cents per dollar
  in taxes.
• How does the governments planned deficit affect
  the economy?
• Federal government deficits are not new. Apart
  from four years 1998?2001, the federal government
  has had a budget deficit.
• How do government deficits and the debt they
  bring affect the economy?

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The Federal Budget

• The federal budget is the annual statement of the
  federal governments outlays and tax revenues.
• The federal budget has two purposes
• 1. To finance the activities of the federal
  government
• 2. To achieve macroeconomic objectives
• Fiscal policy is the use of the federal budget to
  achieve macroeconomic objectives, such as full
  employment, sustained economic growth, and price
  level stability.

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The Federal Budget

• The Institutions and Laws
• The President and Congress make fiscal policy.
• Figure 14.1 shows the timeline for the 2007
  budget.

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The Federal Budget

• Employment Act of 1946
• Fiscal policy operates within the framework of
  the Employment Act of 1946 in which Congress
  declared that
• . . . it is the continuing policy and
  responsibility of
• the Federal Government to use all practicable
  means
• . . . to coordinate and utilize all its plans,
  functions,
• and resources . . . to promote maximum
  employment,
• production, and purchasing power.

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The Federal Budget

• The Council of Economic Advisers
• The Council of Economic Advisers monitors the
  economy and keeps the President and the public
  well informed about the current state of the
  economy and the best available forecasts of where
  it is heading.
• This economic intelligence activity is one source
  of data that informs the budget-making process.

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The Federal Budget

• Highlights of the 2007 Budget
• The projected fiscal 2007 Federal Budget has
  revenues of 2,521 billion, outlays of 2,891
  billion, and a projected deficit of 370 billion.
• Revenues come from personal income taxes, social
  security taxes, corporate income taxes, and
  indirect taxes.
• Personal income taxes are the largest revenue
  source.
• Outlays are transfer payments, expenditure on
  goods and services, and debt interest.
• Transfer payments are the largest item of outlays.

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The Federal Budget

• Surplus or Deficit
• The federal governments budget balance equals
  tax revenue minus outlays.
• If revenues exceed outlays, the government has a
  budget surplus.
• If outlays exceed revenues, the government has a
  budget deficit.
• If revenues equal outlays, the government has a
  balanced budget.
• The projected budget deficit in fiscal 2007 is
  370 billion.

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The Federal Budget

• The Budget in Historical Perspective
• Figure 14.1 on the next slide shows the
  governments tax revenues, outlays, and budget
  surplus or deficit as a percentage of GDP for the
  period 1980 to 2006.
• The government deficit peaked at 5.2 percent of
  GDP in 1983.
• The deficit declined through 1989 but climbed
  again during the 19901991 recession and then
  began to shrink.
• In 1998, a surplus emerged.
• But by 2002, the budget was again in deficit.

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The Federal Budget
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The Federal Budget
Revenues

• Figure 14.2 shows revenues as a percentage of GDP.

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The Federal Budget
Outlays

• Figure 14.3 shows outlays as a percentage of GDP.

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The Federal Budget
Budget Balance and Debt

• Government debt is the total amount that the
  government has borrowed. It is the sum of past
  deficits minus past surpluses.
• Figure 14.4 shows the federal governments gross
  debt
• and net debt.

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The Federal Budget

• The U.S. Government Budget in Global Perspective
• Figure 14.5 compares government budget deficits
  around the world in 2006.
• Governments in most countries had budget deficits
  in 2006.
• A few governments have budget surpluses.

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The Federal Budget

• State and Local Budgets
• The total government sector includes state and
  local governments as well as the federal
  government.
• In 2005, when federal government outlays were
  about 2,500 billion, state and local outlays
  were almost 1,700 billion.
• Most of state expenditures were on public
  schools, colleges, and universities (550
  billion) local police and fire services and
  roads.

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The Supply-Side Employment and Potential GDP

• Fiscal policy has important effects employment,
  potential GDP, and aggregate supplycalled
  supply-side effects.
• An income tax changes full employment and
  potential GDP.

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The Supply-Side Employment and Potential GDP

• Full Employment and Potential GDP
• Figure 14.6(a) illustrates the effects of an
  income tax in the labour market.
• The supply of labour decreases because the tax
  decreases the after-tax wage rate.

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The Supply-Side Employment and Potential GDP

• The before-tax real wage rate rises but the
  after-tax real wage rate falls.
• The quantity of labour employed decreases.
• The gap created between the before-tax and
  after-tax wage rates is called the tax wedge.

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The Supply-Side Employment and Potential GDP

• When the quantity of labour employed decreases,
• ... potential GDP decreases.
• The supply-side effect of a rise in the income
  tax decreases potential GDP and decreases
  aggregate supply.

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The Supply-Side Employment and Potential GDP

• Taxes on Expenditure and the Tax Wedge
• Taxes on consumption expenditure add to the tax
  wedge.

• Figure 14.7 shows some real-world tax wedges.
• The U.S. tax wedge is relatively small.

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The Supply-Side Employment and Potential GDP

• Tax Revenues and the Laffer Curve
• The relationship between the tax rate and the
  amount of tax revenue collected is called the
  Laffer curve.
• For a tax rate below T a rise in the tax rate
  increases tax revenue.

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The Supply-Side Investment, Saving, and Economic
Growth

• Sources of Investment Finance
• GDP C I G (X M)
• And
• GDP C S T
• So I G (X M) S T
• I S (T G) (M X)
• Private saving PS S (M X)
• So I PS (T G)

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The Supply-Side Investment, Saving, and Economic
Growth

• I PS (T G)
• If T exceeds G, the government sector has a
  budget surplus and government saving (T G) is
  positive.
• If G exceeds T, the government sector has a
  budget deficit and government saving (T G) is
  negative.
• Figure 14.9 on the next slide shows the sources
  of investment finance in the United States.

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The Supply-Side Investment, Saving, and Economic
Growth
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The Supply-Side Investment, Saving, and Economic
Growth

• Fiscal policy influences investment and saving in
  two ways
• Taxes affect the incentive to save and change
  the supply of loanable funds.
• Government saving is a component of total saving
  and the supply of loanable funds.

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The Supply-Side Employment and Potential GDP

• Taxes and the Incentive to Save
• Figure 14.10 illustrates the effects of a tax on
  capital income.
• A tax decreases the supplyof loanable funds, and
  
• a tax wedge is driven between the interest rate
  and the after-tax interest rate.
• Investment and saving decrease.

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The Supply-Side Employment and Potential GDP

• Government Saving
• Figure 14.11 illustrates a crowding-out effect of
  a budget deficit.
• With a balanced budget, the supply of loanable
  funds is the private supply PSLF.
• A budget deficit decreases the supply of loanable
  funds

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The Supply-Side Employment and Potential GDP

• The supply of loanable funds is SLF.
• The interest rate rises and investment decreases.
• The higher interest rate increases private
  saving.
• The tendency for the budget deficit to decrease
  investment is called the crowding-out effect.

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The Supply-Side Employment and Potential GDP

• In the crowding-out case, the quantity of private
  saving changes along the PSLF curve as the real
  interest rate rises.
• But suppose that the budget deficit (government
  borrowing) changes private saving and shifts the
  PSLF curve. This possibility is called the
  Ricardo-Barro effect.
• Ricardo-Barro equivalence is the proposition that
  taxes and government borrowing are
  equivalentbudget deficit has no effect on the
  real interest rate or investment.

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Generational Effects of Fiscal Policy

• Is the budget deficit a burden of future
  generations?
• Is the budget deficit the only burden of future
  generations?
• What about the deficit in the Social Security
  fund?
• Does it matter who owns the bonds that the
  government sells to finance its deficit?
• To answer questions like these, we use a tool
  called generation accounting.
• Generational accounting is an accounting system
  that measures the lifetime tax burden and
  benefits of each generation.

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Generational Effects of Fiscal Policy

• Generational Accounting and Present Value
• Taxes are paid by people with jobs. Social
  security benefits are paid to people after they
  retire.
• So to compare the value of an amount of money at
  one date (working years) with that at a later
  date (retirement years), we use the concept of
  present value.
• A present value is an amount of money that, if
  invested today, will grow to equal a given future
  amount when the interest that it earns is taken
  into account.
• If the interest rate is 5 percent a year, 1,000
  invested in 2006 will grow, with interest, to
  11,467 after 50 years.
• The present value (in 2006) of 11,467 in 2056 is
  1,000.

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Generational Effects of Fiscal Policy

• The Social Security Time Bomb
• Using generational accounting and present values,
  economists have found that the federal government
  is facing a Social Security time bomb!
• In 2008, the first of the baby boomers will start
  collecting Social Security pensions and in 2011,
  they will become eligible for Medicare benefits.
• By 2030, all the baby boomers will have retired
  and, compared to 2006, the population supported
  by Social Security will have doubled.

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Generational Effects of Fiscal Policy

• Under the existing Social Security laws, the
  federal government has an obligation to pay
  pensions and Medicare benefits on an already
  declared scale.
• To assess the full extent of the governments
  obligations, economists use the concept of fiscal
  imbalance.
• Fiscal imbalance is the present value of the
  governments commitments to pay benefits minus
  the present value of its tax revenues.
• Gokhale and Smetters estimated that the fiscal
  imbalance was 45 trillion in 20034 times the
  value of total production in 2003 (11 trillion).

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Generational Effects of Fiscal Policy

• Generational Imbalance
• Generational imbalance is the division of the
  fiscal imbalance between the current and future
  generations, assuming that the current generation
  will enjoy the existing levels of taxes and
  benefits.
• The bars show the scale of the fiscal imbalance.

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Generational Effects of Fiscal Policy

• International Debt
• How much investment have we paid for by borrowing
  from the rest of the world? And how much U.S.
  government debt is held abroad?
• In June 2006, the United States had a net debt to
  the rest of the world of 5.2 trillion.
• Of that debt, 2.2 trillion was U.S. government
  debt.
• Total U.S. government debt is 4.1 trillion.
• So more than half of the outstanding government
  debt is held by foreigners.

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Stabilizing the Business Cycle

• Fiscal policy actions that seek to stabilize the
  business cycle work by changing aggregate demand.
• Discretionary or
• 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 Expenditure Multiplier
• The government expenditure multiplier is the
  magnification effect of a change in government
  expenditure on goods and services on aggregate
  demand.
• A multiplier exists because government
  expenditure is a component of aggregate
  expenditure.
• An increase in government expenditure increases
  income, which induces additional consumption
  expenditure and which in turn increases aggregate
  demand.

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Stabilizing the Business Cycle

• The Autonomous Tax Multiplier
• The autonomous tax multiplier is the
  magnification effect a change in autonomous taxes
  on aggregate demand.
• A decrease in autonomous taxes increases
  disposable income, which increases consumption
  expenditure and increases aggregate demand.
• The magnitude of the autonomous tax multiplier is
  smaller than the government expenditure
  multiplier because the a 1 tax cut induces less
  than a 1 increase in consumption expenditure.

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Stabilizing the Business Cycle

• The Balanced Budget Multiplier
• The balanced tax multiplier is the magnification
  effect on aggregate demand of a simultaneous
  change in government expenditure and taxes that
  leaves the budget balance unchanged.
• The balanced budget multiplier is positive
  because a 1 increase in government expenditure
  increases aggregate demand by more than a 1
  increase in taxes decreases aggregate demand.
• So when both government expenditure and taxes
  increase by 1, aggregate demand increases.

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Stabilizing the Business Cycle

• Discretionary Fiscal Stabilization
• Figure 14.13 shows how fiscal policy might close
  a recessionary gap.
• An increase in government expenditure or a tax
  cut increases aggregate demand.
• The multiplier process increases aggregate demand
  further.

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Stabilizing the Business Cycle

• Figure 14.14 shows how fiscal policy might close
  an inflationary gap.
• A decrease in government expenditure or a tax
  increase decreases aggregate demand.
• The multiplier process decreases aggregate demand
  further.

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Stabilizing the Business Cycle

• Limitations of Discretionary Fiscal Policy
• The use of discretionary fiscal policy is
  seriously hampered by three time lags
• Recognition lagthe time it takes to figure out
  that fiscal policy action is needed.
• Law-making lagthe time it takes Congress to
  pass the laws needed to change taxes or
  spending.
• Impact lagthe time it takes from passing a tax
  or spending change to its effect on real GDP
  being felt.

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Stabilizing the Business Cycle

• Automatic Stabilizers
• Automatic stabilizers are mechanisms that
  stabilize real GDP without explicit action by the
  government.
• Induced taxes and needs-tested spending are
  automatic stabilizers.
• Taxes that vary with real GDP are called induced
  taxes.
• When real GDP increases in an expansion, wages
  and profits rise, so the taxes on these
  incomesinduced taxesrise.
• When real GDP decreases in a recession, wages and
  profits fall, so the induced taxes on these
  incomes fall.

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Stabilizing the Business Cycle

• The spending on programs that pay benefits to
  suitably qualified people and businesses is
  called needs-tested spending.
• When the economy is in a recession, unemployment
  is high and needs-tested spending on unemployment
  benefits and food stamps increases.
• When the economy expands, unemployment falls, and
  needs-tested spending decreases.
• Induced taxes and needs-tested spending decrease
  the multiplier effects of changes in autonomous
  expenditure.
• So they moderate both expansions and recessions
  and make real GDP more stable.

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Stabilizing the Business Cycle
Budget Deficit Over the Business Cycle

• Figure 14.15 shows the budget deficit over the
  business cycle from 1980 to 2005.
• Recessions are highlighted.
• During a recession, the budget deficit increases.

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Stabilizing the Business Cycle

• Cyclical and Structural Balances
• 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 14.16 illustrates the distinction between
  a structural and cyclical surplus and deficit.
• In part (a), potential GDP is 12 trillion.
• As real GDP fluctuates around potential GDP, a
  cyclical deficit or cyclical surplus arises.

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Stabilizing the Business Cycle

• In part (b), if real GDP and potential GDP are
  11 trillion, the budget deficit is a structural
  deficit.
• If real GDP and potential GDP are 12 trillion,
  the budget is balanced.
• If real GDP and potential GDP are 13 trillion,
  the budget surplus is a structural surplus.

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THE END