7/2/2015© 2002 Claudia Garcia-Szekely1 Fiscal Policy Claudia Garcia-Szekely

04/19/23 © 2002 Claudia Garcia-Szekely 1

Fiscal Policy

Claudia Garcia-Szekely

War is the mother of taxes

Saint Gregory Nazianzus


And also the mother of inflation…

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"We're going to be putting money in people's pockets so that they can spend on buying a new computer for their kid's school, so that they can, you know, make sure that they are able to deal with heat and groceries and all the other strains on the family budget,“

President elect, Obama.


Fiscal Policy

Changes in Government Spending and/ or Taxes.Induce a change in Aggregate Spending.

Increase AEExpansionary PolicyExpansionary Policy

Decrease AE Contractionary PolicyContractionary Policy


Expansionary Policy

Increase Government Spending (G)And or

Decrease Taxes (T)

Increase AE Increase Output and Employment

Rest of World

HouseholdsFirms

Circular Flow Diagram

G

Total Produced

National Income

generated from

production

National Income - Taxes + Transfers

to

G


Disposable Income is Income available for consumption.

Income generated from production is used to:

Buy goods and services: C.Save: SPay taxes: Tx

The government pays “income transfers” to households.

Social SecurityWelfareUnemployment benefits


Adding Net Taxes

The government collects taxes

The government pays Transfers

We are only interested in the NET effect on Incomes.

Use Tx for TaxesUse Tx for Taxes

Use Tr for TransfersUse Tr for Transfers

Use T for Net Taxes = Tx - TrUse T for Net Taxes = Tx - Tr


Net TaxesT = Tx - Tr

Net amount paid in taxes to the government after subtracting transfers


FixedTaxes (Lump Sum)

Fixed taxes do not change with income.


Disposable IncomeYd = Y - T

Income left after:•Paying taxes•Receiving Government TransfersIncome available for Consumption and Saving


The effect of the tax cutC = a + b YdC = a + b (Y-T)C = a + bY- bTC = (a – bT) + bY

A tax cut increases or increase in transfers the intercept of the consumption function.

Changes in T shift the Consumption Function.

Fixed taxes change the

intercept of the consumption

function


Government Spending and Taxes affect AE differently

GovernmentSpending (G)Enters directly into AE AE = C+I+G

Enter indirectly into AE via C

AE = +I+G+

C

Taxes, transfers(T)


The effect of a 70 tax cut

When Taxes Decrease by T = -70

Consumers have70 more to spend

Disposable Income increase byYd = 70

When Yd = 70 C = a + MPC(Yd)C increase byC = 0.9 (70)

When C = 63 AE = C + I + GAE increase by

AE = C = 63

When AE = 63AE = C + I + G AE line shifts up

by 63.


The effect of A Decrease in Taxes: T = -70 MPC = 0.9

AE = C=-T(MPC)=-(-70)(0.9) =63

AE= C+I+G

450AE= C+I+G

Taxes change by (T)=-70

Yd =Y-T change by –

(T)=70Consumption changes by

–(T)MPC=70(0.9)

AE shifts up by –(T)MPC

63

Y = C(1/1-MPC)Y = 63(1/1-0.9)Y = 63(10)=630

630

Y = 63(10)

C =630*0.9=567

C =700*0.9=630


The effect of A Change in Government Spending

AE = G = 70

AE0

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AE1

If government Spendingincreases by G = 70AE line Shifts up

by AE= G = 70

Y = G(Multiplier)

Equilibrium Income increases by:Y = 70(1/1-MPC) G =70

Y = 700


The Tax Multiplier is smaller than the G Multiplier

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63

630

Y = 63(10)

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Y = 70(10)

70070

Taxes decrease by 70 G increases by 70

AE1

AE0

AE1

AE0

An extra $70 in your hands doesn’t go as far as the same $70

spent by the government! Why?


Government Spending vs. Tax Cuts

The $787 B stimulus package includes $70 billion in tax cuts, which some economists believe will not create as many new jobs as $70 billion in spending would…

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Y0 Y1

AD0

AD1

P0

Y1

The size of the change in equilibrium Y is the size of the shift in AD

AE0

AE1

Y0

When taxes decrease by 70

70*MPC * Multiplier

MPC=0.9

70*0.9

70*0.9 * 10

630

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Y0 Y1

AD0

AD1

P0

Y1

The size of the change in equilibrium Y is the size of the shift in AD

AE0

AE1

Y0

When G increases by 70

70* Multiplier

MPC=0.9

70

70*10

700

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Output

The G Multiplier

Y0 Y1

c

Y = G (1/(1-b))Y = G + CIncomes Increase

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Output

The G Multiplier

Y

= + Y = G + C

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Output

The G Multiplier

Y0 Y1

c

Y = G (1/(1-b))Y = c + CIncomes Increase

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Output

The T Multiplier

Y

= + Y = C + C

Change in ConsumptionWhen government spending changes:

The resulting change in spending is the sum of the extra government spending + extra consumption induced by the increase in incomes

Y = G + C

C = Y – GC = 700 – 70 =630

When taxes change all the resulting change in spending is the extra consumption induced by the increase in incomes:

C = Y = 630

Changes in Budget Deficit

When government spending changes, the resulting change in the Budget Deficit is:

Deficit = G= 70 When taxes change, the resulting change in the Budget Deficit is:

Deficit = -T=-(-70)


Y = T[ (1- MPC) ]-(MPC)

The Tax Multiplier

C=-T(MPC)

Y = C x [ (1- MPC)]1

Y = -T(MPC) x[ (1- MPC)]1


The Tax Multiplier

Y = T[ (1- MPC) ]-(MPC)

Y = T[- (MPS) ](MPC)


The Tax Multiplier Formula

A negativeNumber!

Taxes and Output move in opposite directions

Y = T[ (1- MPC) ]-(MPC)

The Tax Multiplier


Y = G[+ (MPS) ]1

Y = T[- (MPS) ](MPC)

Smaller

Negative


The Balanced Budget Multiplier

Captures the effect on equilibrium output from simultaneous identical changes in Taxes and Government Spending


Increase Both G and T by 40

1

1-MPC

Y = G-MPC

1-MPC

Y = T

1

1-0.75

Y = 40-0.75

1-0.75

Y = 40

Y = 40 (4)=160 Y = 40 (-3)=-120Y = 160 – 120= 40

What happens if we finance the extra spending

with higher taxes?


The Balanced Budget Multiplier is ONE

If G = T = 40 Y = 40 (1)

Changes in ConsumptionWhen government spending changes:

The resulting change in spending is the sum of the extra government spending + extra consumption induced by the increase in incomes:

C = Y - GWhen taxes change all the resulting change in spending is the extra consumption induced by the increase in incomes:

C = YBalanced Budget change: multiplier effect is completely eliminated.

There is NO extra consumption because the increase in incomes and consumption triggered by the increase in G is eliminated by the drop in incomes and consumption resulting from higher taxes:

Y= G ; C = 0

Changes in Budget Deficit

When government spending changes, the resulting change in the Budget Deficit is:

Deficit = G When taxes change, the resulting change in the Budget Deficit is:

Deficit = -TWhen both Government Spending and Taxes change by the same amount (a balanced budget change), there is no change in the Budget Deficit :

Deficit = 0

VARIABLE TAXESIncome Tax: changes with income


Variable Taxes: YFixed Taxes

C = a + b(Y-T)C = a + bY – bTC = (a –bT) + bYExample:C = 1000 + 0.9(Y-700)C = 1000 + 0.9*Y –

0.9*700C = (1000 –0.9*700) +

0.9*YC = (1000 – 630) + 0.9Y

Variable Taxes

T= tYC = a + b(Y- tY)C = a + bY-b tYC = a + (b-bt) YExample:C = 1000 + 0.9(Y-0.25Y)C = 1000 + 0.9Y –

0.9*0.25YC = 1000+ Y(0.9-0.9*0.25)C = 1000 + (0.9-0.225)Y

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C and AE Slope =b

C and AE Slope =b-

bt

slope smaller

O.675

Variable Taxes: YFixed Taxes

C = a + b(Y-T)C = a + bY – bTC = (a –bT) + bYExample:C = 1000 + 0.9(Y-700)C = 1000 + 0.9*Y –

0.9*700C = (1000 –0.9*700) +

0.9*YC = (1000 – 630) + 0.9Y

Variable TaxesT=T+ tYC = a + b(Y- (T+tY))C = a + bY-b(T+tY)C = a + bY-bT-btYC = (a –bT)+ (b-bt)YExample:C = 1000 + 0.9(Y-700 -0.25Y)C = (1000 – 630) + (0.9-

0.9*0.25)YC = (1000–630) + Y(0.9-0.225)C = 1000–630 + O.675Y

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C and AE Slope =b

C and AE Slope =b-

bt

Intercept same, slope smaller

Variable taxes make C and AE flatter


C = (a –b

T) + bY

AE = (I+

G+NX+a–bT) +

bY

C = a-bT + (b-bt) Y

a –bT

a-bT

I+G+NX+a–bT

I+G+NX+aAE = (I+G+NX+a) + (b-bt)Y

flatter

Steeper

When T Increases: C shifts down

When t Increases: C becomes flatter

Variable taxes make C and AE flatter

Y=100

C=100*MPC = 100*0.9 = 90

C=100*(MPC-MPC*) = 100*(0.9-0.9*0.25)= 67.5

Part of the increase in income goes to pay taxes so consumption does not increase as much.

Steeper: increase in C is larger

Flatter: increase in C is smaller

C

C

Fixed Taxes Variable Taxes

Y = G

[ (1- b)]1 Y = G[(1-b+b)]1

Y = T[ (1- b)]-b Y = T [(1-b+b)]-b

Variable Taxes(Y) affect the multipliers

Both multipliers become smaller

When rate increases, multiplier decreases

The G multiplier when taxes change with income (Income Taxes)The effect of an increase in G is smaller with income taxes because as income increases, the government taxes a portion of the increase in income.

Y = G + C; C is smaller than beforeThe effect of a tax cut is also smaller with income taxes because as income increases, the government taxes a portion of the increase in income.

Y = C; C is smaller than before

The oversimplified formula overstates the size of the

multiplier


Permanent Tax Cut or Tax Holiday?A tax cut has more potential impact in the long run than a tax holiday.

A payroll tax credit would provide more of a spending boost since it is a permanent change in the tax code

Households are more likely to spend a tax cut if it is the result of a permanent change rather than a temporary oneHouseholds are more likely to save a temporary tax cut.

Condition that must be satisfied for equilibrium:

Y = C + I + G + X-MSince: Y = C + S + T (Income is

used to consume, save and pay taxes)

We can rewrite the equilibrium condition as: C + S + T= C + I + G +X-M

S = I + (G – T)+(X-M)

Rest of World

HouseholdsFirms

S

I

T

G

G

C

Total Incom

e

Total Producti

on

Total S

pending

NX

Open Economy with Government

S+T = I + G + X-MS+T+M = I + G + Xleakages = Injections

Savings must finance Investment, the government’s deficit and the trade

deficit.

S+T+M

I+G+X

Y Equilibrium

Y Equilibrium

AE

I+G+X=S+T+M

Leakages =

Injections

Y above equilibrium

Inventories increase

Inventories fall

Y below equilibrium

Leakages <

Injections

Y < AE

Leakages >

Injections

Y > AE

What is the equilibrium GDP?

For what value of GDP is:Y = AE?

For what value of GDP is:S = I +(G-T) +(X-M)?

At Y = 5,000 are inventories rising? Falling? Unchanged?For what value of GDP is:Y = AE?

At Y = 3,000 are inventories rising? Falling? Unchanged?

I + (G-T) + (X-M)


Automatic Stabilizers

Features of the economy that reduce its sensitivity to

shocks

AUTOMATIC STABILIZERSPersonal Income Taxes



1. Personal Income Taxes

When GDP rises, we earn more income but we also pay more taxes and thus consumption does not rise as much as it would if taxes did not rise with income.When GDP falls, we earn less income but we also pay less taxes and thus consumption does not fall as much as it would if taxes did not fall with income.

AUTOMATIC STABILIZERS

Unemployment Compensation, Income supplements for the poor



2. Unemployment Compensation, Income Supplements for the poor

When GDP falls, more people receive unemployment insurance payments thus dampening the fall in incomes (and consumption) that would occur with a falling GDP.When GDP rises, fewer people receive unemployment insurance payments thus dampening the rise in incomes (and consumption) that comes with a rising GDP.

Chart 2-3. The Federal Government Dollar— Where It Comes From


2008

Mandatory

Spending

Discretionary Spending

Fiscal Policy

MPC = 0.9. Find G/T necessary to close the gap.Calculate for each C, Deficit.

Fiscal Policy

MPC = 0.9. Find G/T necessary to close the gap.Calculate for each C, Deficit.

Effect on C, AE, AD, GDP and prices

Increase (decrease) in taxes (fixed or variable)Increase (decrease) in transfersIncrease (decrease) in G



Example:C = 200 +0.8 (Y-T)I = 300G = 150T = 100

AE = 650 + 0.8 (Y – 100)

Add to get AEAdd to get AE

AE =650 – 0.8(100) + 0.8Y

AE = 570 + 0.8YAE = 570 + 0.8Y


Equilibrium Output

AE = 570 + 0.8Y

Set Y = AE and solve for Y:

Y = 570 + 0.8 Y

Y – 0.8Y = 570

Y(1-0.8) = 570

Y = 570/0.2

Y = 2,850Y = 2,850


EquilibriumC = 200 +0.8 (Y-T)I = 300G = 150T = 100

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AE=2,850

Y=2,850

AE = 570+0.8Y

570

- 80

C = 200 +0.8 (2,850-100)

I = 300G = 150T = 100

AE = 570+0.8Y

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S+T

I+G

Y=2,850

Y=2,850

AE=2,850

I+G=S+T

S = Y-C-T

S = 2,850 – 2,400-100

C = 2,400

S = 350 T = 100+

450

450

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7/2/2015© 2002 Claudia Garcia-Szekely1 Fiscal Policy Claudia Garcia-Szekely