Fiscal Policy Economics, Sixth Edition Boyes/Melvin Chapter 12

Fiscal PolicyFiscal Policy

Economics, Sixth EditionEconomics, Sixth Edition

Boyes/MelvinBoyes/Melvin

Chapter 12Chapter 12

Expansion and Contraction with Expansion and Contraction with Fiscal PolicyFiscal PolicyExpansionary Policy (Stimulus)

– Increase Government Purchases– Increase Transfer Payments

– Reduce Taxes

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Expansion and Contraction with Expansion and Contraction with Fiscal PolicyFiscal PolicyContractionary Policy (Resist

inflation)

– Reduce Government Purchases– Reduce Transfer Payments

– Increase Taxes

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Demand-Side Policy: Demand-Side Policy: Increased Spending Increased Spending Increases Aggregate Increases Aggregate DemandDemand

Real GDP

Pri

ce

Le

ve

l

(c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.)

AD1

AD

Y?

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Spending MultiplierSpending Multiplier

$1 Increased Spending is multiplied by the Spending Multiplier

Spending Multiplier: (chapter 11)

__1__Leakages

Note: leakages are: saving rate + import rate

(all stated in their decimal forms)

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Analysis of a Analysis of a Tax-and-Spend Tax-and-Spend PolicyPolicy

Government increases spending, but finances it with tax increases. The increase in spending shifts AD to the right, but the increase in taxes reduces the incentive to work, shift AS to the left.

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Ricardian Equivalence ThesisRicardian Equivalence Thesis

If Government increases spending without increasing taxes, consumers and firms recognize that future taxes must rise. Therefore, they save more now and reduce private spending. The increased savings cancels out the increased government purchases in their effect on AD.

Increased Govt. Spending will have no positive impact on AD.– David Ricardo proposed this, and then rejected it in the

1800s. Some (few) economists now assert its relevance again.

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Crowding OutCrowding Out

The issue of crowding out is usually raised in the context of increased government spending (G) financed by the issue of debt. Essentially, the government borrows the money it will spend.

The government’s demand for credit drives up interest rates.

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Crowding Out (cont.)Crowding Out (cont.)

Higher interest rates result in higher financing costs for firms, and therefore lower investment spending, offsetting (partially or fully) the GDP gains from the increase in government spending.

That is, private investment is “crowded out” by debt-financed public (gov’t) spending.

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Other implications of Other implications of Budget Deficits and National DebtBudget Deficits and National Debt The crowding out of private investment means a

smaller future capital stock. This implies lower output in the future.

Higher interest rates will also cause the currency to appreciate, making foreign currencies and goods cheaper. Imports increase, hence net exports decrease, reducing GDP. This is international crowding out.

The higher the national debt (rising because of budget deficits), the higher the interest payments (debt service) paid by the government.

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The Making of U.S. Fiscal PolicyThe Making of U.S. Fiscal Policy

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Complications of Fiscal PolicyComplications of Fiscal Policy

Lag times– Recognition Lag– Policy decision Lag– Implementation Lag– Impact lag

A discretionary fiscal policy (one that is NOT an automatic stabilizer) has such long lag times as to be ineffective as a response to cyclical macroeconomic conditions.

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Complications of Fiscal PolicyComplications of Fiscal Policy

Electoral incentives– Expansionary policy is easy

• Tax cuts• Spending increases

– Contractionary policy is difficult• Tax increases• Spending cuts

– Bias for inflationary over-stimulation– Tendency to run deficits

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U.S. Government U.S. Government Revenues and Revenues and ExpendituresExpenditures

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U.S. Government Expenditures U.S. Government Expenditures as a Percentage of GDPas a Percentage of GDP

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Updated National Debt/Deficit DataUpdated National Debt/Deficit Data

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More More Updated Updated Data on Data on US DebtUS Debt

U.S. NATIONAL DEBT CLOCKU.S. NATIONAL DEBT CLOCK

The Outstanding Public Debt as of 13 Apr 2009 at 11:59:56 PM GMT is:

$11,181,629,735,978.62 The estimated population of the United States is

305,996,271so each citizen's share of this debt is $36,541.72.

The National Debt has continued to increase an average of$3.86 billion per day since September 28, 2007

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Outstanding Public Debt as of 07 Apr 2010 at 05:59:13 PM GMT is:

The estimated population of the United States is 308,151,423so each citizen's share of this debt is $41,518.83.

The National Debt has continued to increase an average of$4.11 billion per day since September 28, 2007.

http://www.brillig.com/debt_clock/

The Outstanding US Public Debt as of

02 May 2011 at 03:45:27 PM GMT is:

The estimated population of the United States is 310,493,752, so each citizen's share of this debt is $46,048.21.

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Demand-side policies: policies designed to stimulate or slow aggregate demand (focusing on Consumption & Government purchases).

Supply-side policies: policies designed to stimulate or slow aggregate demand (focusing on Investment).

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Discretionary Fiscal Policy: changes in government spending and/or taxation aimed at achieving a policy goal.

Automatic Stabilizer: an element of fiscal policy that changes automatically as income changes.

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TaxesTaxes

Two types of taxes:– direct taxes: on individuals and firms.

For example, personal income taxes, business income taxes, SSI, FICA

– indirect taxes: on goods and services. For example, sales taxes, and value-added taxes (VAT).

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TaxesTaxes

Three types of tax rate structures:– progressive tax: rate increases with higher

income; wealthy pay a higher percentage. (examples: federal income tax, CA state income tax)

– regressive tax: rate falls with higher income; wealthy pay a lower percentage. (examples: SSI, FICA, sales tax, gasoline tax, VAT)

– proportional tax: rate is constant; everyone pays the same percentage. (for example a 10% flat tax – no real examples in US)

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Automatic StabilizersAutomatic Stabilizers

Progressive Taxes– As income falls, the tax rate also falls,

helping to maintain buying power, hence maintaining aggregate demand• Income taxes• Corporate income taxes• Capital gains taxes

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Automatic StabilizersAutomatic Stabilizers

Transfer Payments: Insure that buying power is not reduced at the same rate as income– Unemployment insurance– Welfare– Subsidies (farm income supports, etc.)

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Demand-Side Policy: Demand-Side Policy: Increased Spending Increased Spending Increases Aggregate Increases Aggregate DemandDemand

Real GDP

Pri

ce

Le

ve

l

(c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.)

AD1

AD

Y?

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Aggregate Aggregate Demand and Demand and Supply Supply EquilibriumEquilibrium

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Central Government Spending by Central Government Spending by Functional CategoryFunctional Category

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Central Government Tax Composition Central Government Tax Composition by Income Groupby Income Group

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Central Government Tax Composition Central Government Tax Composition by Income Groupby Income Group

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Supply-Side Supply-Side Economics Economics and the and the Laffer CurveLaffer Curve

Taxes are a disincentive to productive activity. As marginal tax rates rise, the disincentive effects also grow, shrinking the tax base. At marginal tax rates greater than t, the tax base shrinks at a faster rate than the increases in marginal tax rate. The net result is that increases in marginal tax rates beyond t result in reduced tax revenues.

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The Laffer Curve and Public PolicyThe Laffer Curve and Public Policy

Reagan Administration argument: Taxes were too high, reduce taxes and revenue will increase.– Reduced Corporate and higher income taxes– Increased Government spending– Result: Growing GDP, but with rising deficits, rising

debts G.W. Bush Administration: Same argument, same

result– Reduced corporate and higher income taxes– Increased spending– Result: Growing GDP, but with rising deficits, rising

debts

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US Taxes In ComparisonUS Taxes In Comparison

Marginal Income Tax Rates: US: 15% - 28% (top bracket reduced in 2002 from 39.6%)

Japan: 10% - 40% UK: 10% - 40% Germany: 23.9%-53% France: 10.5% - 54%

Documents

Fiscal Policy Economics, Sixth Edition Boyes/Melvin Chapter 12