Ch. 13: Fiscal Policy

• Federal budget process and recent history of outlays, tax revenues, deficits, and debts

• Supply-Side Economics• Controversies on effects of deficits on investment,

saving, and economic growth• Fiscal policy as a stabilization tool

The Federal Budget and Fiscal Policy

Federal budget• annual statement of the federal government’s outlays and tax

revenues.• Two purposes

o finance the activities of the federal governmento achieve macroeconomic objectives

Fiscal policy • the use of the federal budget to achieve macroeconomic

objectives

• Employment Act of 1946

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.

(Normal) Timeline for Budget Process

February to March President submits budget request to Congress.

May-August:House and Senate revise/amend proposals

September House-Senate conference committees resolve differences and agree on final versions of spending bills. President signs or vetoes final bills.

October 1 Beginning of fiscal year (10/1/2012 is beginning of 2013 fiscal year).

Congress passes continuing resolutions to maintain funding for any agencies affected by appropriations bills that have not been passed and signed by the beginning of the fiscal year.

Fiscal Policy

The Council of Economic Advisors• Chaired by Alan Krueger• keeps the President and public informed about the

current state of the economy • evaluates economic proposals• Provides data to inform the budget-making process.

Congressional Budget Office• Forecasts effects of legislative changes on budget and

economy

Federal Deficits and Public Debt

Budgett = revenuet –outlayst

• if Budgett > 0 budget surplus

• if Budgett < 0 budget deficit

• (outlays include interest on debt)

Debtt = Debtt-1 - budgett-1

• Budget deficits increase debt• Budget surpluses decrease debt

Revenues

Outlays

The Federal Budget

Baseline budget assume current tax and spending laws remain unchanged.

The National Debt

• The total government sector includes state and local governments as well as the federal government.

• In 2008, when federal government outlays were about $3,200 billion, state and local outlays were a further $2,000 billion.

• Most of state expenditures were on public schools, colleges, and universities ($550 billion); local police and fire services; and roads.

• Most states have “balanced budget amendments”.

State and Local Budgets

Supply-Side Economics

Fiscal policy aimed at increasing LAS• Income taxes affect LAS by affecting labor supply.• Higher income taxes reduce labor supply & reduce LAS• “Supply-siders” argue for low marginal tax rates.

Graph the effect of an increase in income tax rate on• before-tax real wage rate, after-tax real wage rate.

• Tax-wedge (difference between before and after tax wage)

• Equilibrium employment

• LAS

Effect of an increase in income tax rate

Tax Wedge Comparisons

Federal Income Tax Marginal Rates

2011 Federal Income Tax Marginal Rates

Source: http://www.cbo.gov/publications/collections/tax/2010/graphics.cfm

Share of income paid in taxes

Source: http://www.cbo.gov/publications/collections/tax/2010/graphics.cfm

Source: http://www.cbo.gov/publications/collections/tax/2010/graphics.cfm

Average Federal Tax Rate by Income Quintile, 1979-2007(note: all federal taxes included)

The Supply-Side: The Laffer Curve.

Tax Revenue

Tax Rates

The Laffer Curve

As tax rates rise, taxable income may fall because• People reduce work hours• Tax avoidance increases

oLegal tax avoidance– Charities– Tax free bonds– Pension saving– Capital gains versus income

o Illegal tax avoidance– Under-report income– Inflate deductions

Laffer Curve and Capital Gains Tax

Source: http://time-blog.com/curious_capitalist/2008/01/do_capital_gains_tax_cuts_incr.html

Laffer curve and corporate income tax rate – tax havens video

According to the Laffer curve, if tax rates rise, tax revenue

Will

rise

May r

ise or f

a...

Will

fall

0% 0%0%

a) Will rise

b) May rise or fall

c) Will fall

10

The Supply-Side: Investment and Saving

GDP = C + I + G + (X – M) GDP = C + S + T

I + G + (X – M) = S + T I = S + (T – G) + (M – X)

Private saving PS = S + (M – X)

Government Saving GS=T-G

I = PS + GS

The Supply-Side: Investment and Saving

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.

The Supply-Side: Investment and Saving

A tax on capital income decreases the supplyof loanable funds

a tax wedge is driven between the interest rate and the after-tax interest rate

Investment and saving decrease.

The Supply-Side: Investment and Saving

Ricardo-Barro Equivalence• In above diagram, it is assumed that government

budget does not shift PSLF curve.• Ricardo-Barro:

oLarger deficits cause households to increase savings in order to cover future tax increases.

oNet effect of larger deficit on SLF curve is zero because PSLF curve shifts right.

oNo effect on investment or interest ratesoAll increases in deficits are offset by increased

saving (decreased consumption).

Stabilizing the Business Cycle

Discretionary fiscal policy • action that is initiated by an act of Congress.

Automatic fiscal policy (Auto stabilizers)• fiscal policy triggered by the state of the economy.

Stabilizing the Business Cycle

Discretionary Fiscal Stabilization• An increase in

government expenditure or a tax cut increases aggregate demand.

• The “multiplier process” increases aggregate demand further.

• Size of multiplier is controversial.

Stabilizing the Business Cycle

• A decrease in government expenditure or a tax increase decreases aggregate demand.

• The multiplier process decreases aggregate demand further.

Stabilizing the Business Cycle

Limitations of Discretionary Fiscal Policy• Recognition lag

o time it takes to figure out that fiscal policy action is needed.

oLaw-making lag– time it takes Congress to pass the laws needed to change

taxes or spending.

o Impact lag– time it takes from passing a tax or spending change to its

effect on real GDP being felt.

Stabilizing the Business Cycle

Automatic Stabilizers• mechanisms that stabilize real GDP without explicit

action by the government.• Taxes that rise and fall with GDP taxes and needs-

tested spending are automatic stabilizers.

• When real GDP decreases in a recession• wages and profits fall, so taxes fall• Needs-tested spending rises• Budget deficit grows (surplus shrinks)

The Budget and the Business Cycle

Cyclical and Structural Balances Actual Budget = Cyclical Budget + Structural Budget

• The structural surplus or deficit • 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 • the surplus or deficit that occurs purely because real

GDP does not equal potential GDP.• Cyclical budget < 0 if GDP< potential GDP

Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/01-26_FY2011Outlook.pdf

Effects of economy on budget

Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/01-26_FY2011Outlook.pdf

Effects of economy on budget

Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/01-26_FY2011Outlook.pdf

Cyclical and Structural Budget