MAC Module 15 - Fiscal Policy

The federal budget has two purposes:

to finance the activities of the federal government and to achieve macroeconomic objectives. 

we use a tool called generational accounting—an accounting system that measures two indicators of the true state of the government’s budget:

Fiscal imbalance

Generational imbalance

Fiscal imbalance measures the government’s true debt.

 It measures today’s value of the future cost of the programs to which the government is committed minus today’s value of the future taxes it will collect.

How can the federal government meet its Social Security and Medicare obligations? There are four alternative ways:

1. Raise income taxes

2. Raise Social Security taxes

3. Cut Social Security benefits

4. Cut other federal government spending

discretionary fiscal policy is seriously hampered by many factors, four of which are

• Lawmaking time lag

• Shrinking area of lawmaker discretion

• Estimating potential GDP

• Economic forecasting

During the 2000s, federal spending increased faster than in any other peacetime period. This growth in spending was driven by two forces:

increased security threats and an aging population.

a tax cut has two effects:

It increases aggregate demand by boosting consumption expenditure and it increases potential GDP.

Fiscal policy influences the economic growth rate in two ways:

First, taxes drive a wedge between the interest rate paid by borrowers and the interest rate received by lenders. This wedge lowers the amount of saving and investment and slows the economic growth rate.

Second, if the government has a budget deficit, then government borrowing to finance the deficit competes with firms’ borrowing to finance investment and to some degree, government borrowing “crowds out” private investment.

The federal budget is

an annual statement of the outlays, tax revenues, and budget surplus or deficit of the government of the United States.

Fiscal policy is the use of

the federal budget to finance the federal government and to influence macroeconomic performance.

 An ever rising national debt and large fiscal imbalance

a major fiscal policy challenge.

Fiscal policy can be

discretionary or automatic.

Changes in government expenditure and changes in taxes have

multiplier effects on aggregate demand and can be used to try to keep real GDP at potential GDP.

In practice, ______ time lags, a shrinking area of lawmaker discretion, the difficulty of estimating _______, and the limitations of economic forecasting seriously hamper ______________.

lawmaking, potential GDP, discretionary fiscal policy

Automatic stabilizers arise because

tax revenues and outlays fluctuate with real GDP.

The provision of public goods and services increases

productivity and increases potential GDP

Income taxes create a wedge between the wage rate paid

by firms and received by workers and lower both employment and potential GDP.

Income taxes create a wedge between the interest rate paid

by firms and received by lenders and lower saving and investment and the

Fiscal Policy

the use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth & full employment

Budget balance =

Tax revenues - Outlays

The government has a balanced budget

when tax revenues equal outlays (budget balance is zero)

The government has a budget surplus

when tax revenues exceed outlays (budget balance is positive)

The government has a budget deficit

when outlays exceed tax revenues (budget balance is negative)

The government borrows to finance

a budget deficit and repays its debt when it has a budget surplus

National debt

The amount of debt outstanding that a arises from past budget deficits

Debt at end of 2020 =

Debt at end of 2019 + Budget deficit in 2020

On the tax revenues side of budget: The largest item is personal income taxes -

taxes that pay on wages and salaries and on interests.

On the tax revenues side of budget: The 2nd largest item is social security taxes

taxes paid by workers and employers to fund social security benefits

On the tax revenues side of budget: Corporate income taxes

which are the taxes paid by corporations on their profits, are much smaller.

On the outlays of the budget: The largest item is transfer payments

Social Security benefits, Medicare and Medicaid benefits, unemployment benefits, and other cash benefits.

On the outlays of the budget: Expenditure on goods and services includes

the government’s defense and homeland security budgets

On the outlays of the budget: Debt interest is

interest on the national debt

To defuse the time bomb, income taxes would need to be raise by -

69 % or Social Security raised by 95% or Social Security benefits cut by 56%.

Fiscal policy is a change in

government outlays or in tax revenues

Other things remaining the same,

a change in any item in the government budget changes aggregate demand

These changes might occur as an

automatic response to the state of the economy or as a result of new spending or tax decisions by Congress

Automatic fiscal policy

a fiscal policy action that is triggered by the state of the economy.

Automatic fiscal policy: For example, an increase in unemployment induces an increase in payments to the -

unemployed or in a recession tax receipts decrease as incomes fall.

Discretionary fiscal policy

A fiscal policy action is initiated by an act of Congress

Discretionary fiscal policy: For example, an increase in defense spending or

a cut in income tax rate

Because tax revenues and outlays fluctuate with real GDP,

they act as automatic stabilizers

The automatic stabilizers are

induced taxes and needs-tested outlays

Induced taxes are

taxes that vary with real GDP, such as sales taxes and income taxes

Needs-tested spending

spending that benefit qualified people and businesses that vary with real GDP, such as unemployment benefits

Because government tax revenues fall and outlays increase in a recession,

the budget provides automatic stimulus that helps to shrink the recessionary gap

Similarly, because tax revenues rise and outlays decrease in a boom,

the budget provides automatic restraint to shrink an inflationary gap

Fluctuations in the government budget balance over the business cycle create a

need to distinguish between the budget’s cyclical balance and structural balance.

A structural surplus or deficit

the budget balance that would occur if the economy were at full employment.

A cyclical surplus or deficit is

the budget balance that arises because tax revenues and outlays are not at their full employment levels.

The actual budget balance is

sum of the structural balance and the cyclical balance.

Discretionary fiscal policy can take the form of a

change in government outlays or a change in tax revenues,

Other things remaining the same, a change in any of the items in the government budget changes aggregate demand and has a multiplier effect —

aggregate demand changes by a greater amount than the initial change in the item in the government budget.

The government expenditure multiplier is

the effect of a change in government expenditure on goods and services on aggregate demand.

An increase in aggregate expenditure increase aggregate demand,

which increases real GDP.

The increase in real GDP induces an increase in consumption expenditure,

which further increases aggregate demand.

Tax multiplier

the effect of a change in taxes on aggregate demand

A decrease in taxes increases

disposable income

The increase in disposable income increases

consumption expenditure and aggregate demand.

With increase in aggregate demand,

employment and real GDP increases and consumption expenditure increases yet further.

So a decrease in taxes works like an

increase in government expenditure.

Both actions increase aggregate demand and

have a multiplier effect

But the magnitude of the tax multiplier is

smaller than the government expenditure multiplier.

The reason: A $1 tax cut doesn’t all get spent. Some is saved. So the increase in aggregate expenditure is less than $1. But a $1 increase in government expenditure increases aggregate expenditure by $1.

Transfer payments multiplier is

the effect of a change in transfer payments on aggregate demand.

This multiplier works like the tax multiplier but

in the opposite direction

An increase in transfer payments increases

disposable income, which increases consumption expenditure.

With increased consumption expenditure, employment and real GDP

increase and consumption expenditure increases yet further.

Balanced budget multiplier is

the effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged.

The balanced budget is not zero —

it is positive — because the government expenditure multiplier is larger than the tax multiplier.

If real GDP is below potential GDP, the government might pursue a fiscal stimulus by:

• Increasing government expenditure on goods and services

• Increasing transfer payments

• Cutting taxes

• A combination of all three

Fiscal policy influences the output gap by changing

aggregate demand and real GDP relative to potential GDP.

But fiscal policy also influences potential GDP and the

growth rate of potential GDP.

Supply-side effect

the effects of fiscal policy on potential GDP

Supply side effects operate

more slowly than the demand-side effects.

Supply-side effects are often ignored in times of recession

when the focus is on fiscal stimulus and restoring full employment.

But in the long run, the supply-side effects of fiscal policy

dominate and determine potential GDP.

Fiscal policy influences the output gap by changing

aggregate demand and real GDP relative to potential GDP.

These influences on potential GDP and economic growth arise because

• The government provides public goods and services that increase productivity

• Taxes change the incentives the people face.

Both sides of the government’s budget influences

potential GDP

The expenditure side provides public goods and services that

enhance productivity.

The increase in productivity increases

potential GDP.

On the revenue side, taxes modify incentives and change the full employment quantity of labor,

as well as the amount of saving and investment

An increase in taxes drives a wedge between

the price paid by the buyer and the price received by a seller.

In the labor marker, tax wedge

the gap between the before-tax rate and the after-tax wage rate.

(Tax wedge) The result is a decrease in the full- employment quantity of labor

and a decrease in potential GDP.

A change in the income tax changes-

equilibrium employment and potential GDP.

In the example that you’ve just work through, the tax rate is about

43% - a $30 tax on a $70 wage rate.

If the income tax rate is increased, the supply of labor

decreases yet more & the LS + tax curve shifts farther leftward.

Equilibrium employment &

potential GDP decrease.

Lenders pay an income tax on the interest -

they receive from borrowers, which creates an interest rate tax wedge.

A tax on interest lowers the quantity of saving and

investments and slows the growth rate of real GDP.

A tax on interest income creates a Lucas wedge —

an ever widening gap between potential GDP and the potential GDP that might have been.

Investment and saving plans depend

on the real after-tax interest rate.

The real interest rate =

the nominal interest rate - the inflation rate

So the after-tax interest rate, not the real interest rate,

determines the amount of tax to be paid; and the higher the inflation rate, the higher is the nominal interest rate, and the higher is the true tax rate on interest income.

A tax cut that increases the budget deficit brings

an increase in the demand of loanable funds to firms.

The interest rate rises and

crowds out private investment.

But the lower income tax rate shrinks the tax wedge and

stimulates employment, saving, and investment.

But a higher budget deficit -

decreases investment.

A fiscal stimulus increases

aggregate demand and potential GDP

When potential GDP increases

aggregate supply increases.