Fiscal Policy and the Federal Budget

Ch. 11, Macroeconomics, Roger A Arnold

The Federal (Government) Budget• Government Budget: A plan for the federal government’s tax

revenues** and expenditures* for the coming year

• Gov Expenditure*= government purchases (G) + transfer payments

• Income tax systems: (Source of tax revenues**)- Progressive income tax: System in which one’s tax rate rises as taxable income rises- Proportional income tax: System in which tax rate is the same regardless of taxable income- Regressive income tax: System in which a person’s tax rate declines as his her taxable income rises

Continued…

The budget can be in one of the three states (11-1e):

1) Budget Deficit*: Gov expenditures > Tax revenues2) Budget Surplus: Tax revenues > Gov expenditures3) Balanced Budget: Gov expense = Tax revenues

*Deficit – two types: cyclical and structural deficits

Hence,Total budget deficit = structural budget deficit + Cyclical deficit

Cyclical deficits: Part of the budget deficit that results from a downturn in economic activity.

e.g. as Real GDP falls, tax base falls, assuming tax rates are held constant, tax revenues will fall. Also, transfer payments will rise. Revenues fall and expenditure rise => deficit increasesThis increase in deficit is cyclical deficit

Structural Deficit: Part of the budget deficit that would exist even if the economy were operating at full employment.

Public Debt: Total amount that the government owes to its creditors

Value-Added TaxExample of value being added to every step in the production process…Farmer sells wheat at $1 to baker. The value added by the farmer is $1

Baker uses wheat to bake bread. And sells to final consumer at $1.40. Value added by baker $0.40.

VAT – tax on the value added at each stage of production.e.g. VAT of 10% => total VAT of $0.14 ($0.1 + $0.4) in the above example

Hence, final consumer now pays $1.54VAT generates tax revenues and raises prices

11-2 Fiscal Policy

• Economic goals: Low unemployment, Price Stability and economic growth

• The government may help an economy achieve this through fiscal policy

• Fiscal Policy: Changes in government expenditures and/or taxes … 2 types …

• Expansionary Fiscal Policy: Increase in government expenditures and/or decrease in taxes

• Contractionary Fiscal Policy: Decrease in government expenditures and/or increase in taxes

continued

If the change in fiscal policy is deliberate then it is said to be discretionary fiscal policy. If government expenditures and taxes change due to economic events it is referred to as automatic fiscal policy.

Two important notes:• Here we focus on discretionary fiscal policy• Any change in government expenditures is due to

change in government purchases. We assume transfer payments are constant

11-3 Demand Side Fiscal Policy

• Exhibit 2. Important. Remember, AD curve shifts if C, I, G or NX changes. In case of expansionary fiscal policy, G increases and taxes decreases (which causes C and/or I to increase). Therefore, AD shifts right. Can be used when the economy is in a recessionary gap.Contractionary fiscal policy shifts the AD curve left due to the opposite reasons…G decreases and C and/or I decreases since taxes are increased. Can be used when the economy is in an inflationary gap.

11-3c Crowding Out

• Crowding Out: The decrease in private expenditures that occurs as a consequence of increase in government spending or the financing needs of a budget deficit

• Direct effect: The government spends more on public libraries and individuals buy fewer books at book-stores

• Indirect effect: The government spends more without raising taxes…borrows more which increases the demand for credit in the credit market causing the interest rate to rise. As a result investment falls.

Types of crowding out:1) Complete crowding out: A decrease in one or more

components of private spending that completely offsets the increase in government spending.

2) Incomplete crowding out: A decrease in one or more components of private spending that partially offsets the decrease the government spending.

3) Zero crowding out: Private spending does not change due to change in government spending

In case of complete crowding out or incomplete crowding out, expansionary fiscal policy will have less impact on AD and Real GDP than theory predicts. Exhibit 3. Important.

11-3d Lags and Fiscal Policy1. The Data Lag. Policy makers are not aware of changes in the

economy as soon as they happen2. The wait-and-see Lag. Cautious wait and see attitude 3. The legislative lag. Lag due to political and bureaucratic process4. The transmission lag: The enactment and implementation5. The Effectiveness Lag: The lag between implementation and

effectBy this time the economic problem 1) may no longer exist2) May not exist to the degree it once did 3) may have changed altogether.

PS. This along with the crowding out are reasons why fiscal policy might not be effective

11-4 Supply Side Fiscal Policy

Marginal Tax Rates and Aggregate SupplyMarginal Tax Rate: The change in a person’s tax payment divided by the change in taxable income:

Lower marginal tax rates might increase the incentive to work…aggregate supply increases

11-4 Laffer Curve: Tax Rates and Tax Revenues

Laffer Curve explains the possible relationship between tax rates and tax revenues. Exhibit 7.

Tax revenues = tax base x average tax rate

Tax base: The total amount of taxable income

Upward sloping portion of the curve in Exhibit 7 indicates direct relationship between tax revenues and tax rates (when percentage decline in tax base is less than the income). Note: We assume tax base falls if tax rate increases. Since people lose incentive to work so total taxable income decreases.The downward sloping portion of the Laffer curve indicates an inverse relationship between tax rate and tax revenue…occurs when the decline in tax base is greater than the percentage increase in average tax rate.