Ch 15 Notes

Ch. 15 Fiscal Policy 

15.1 The Government Budget: Some Facts and Figures

Government Budget Components

Three main aspects:

1. Spending (Outlays)

2. Tax Revenues (Receipts)

3. Budget Surplus or Deficit

Government Outlays (Spending)

Three primary categories:

1. Government purchases (G): Spending on goods/services, including capital goods.

2. Transfer payments (TR): Payments without direct exchange (e.g., Social Security, Medicare, welfare).

3. Net interest payments (INT): Interest paid on government bonds minus interest received from loans.

Additional minor category: Subsidies & government enterprise surpluses.

Trends in Government Spending (as % of GDP)

• World War II: Peak of 45% in 1943-1944.

• Post-1960s: Gradual decline in purchases from 23% to 17% (except during financial crises).

• Transfer payments: Grew from the 1950s to 15% of GDP by 2020-2021 (Medicare, Medicaid expansion).

• Interest payments: Increased significantly during WWII and the 1980s but declined in the 1990s and 2000s.

Comparison with Other OECD Countries (Govt. Spending as % of GDP, 2021)

• US: 45.1% (4th lowest among 18 OECD nations).

• Lowest: Ireland (25.0%).

• Highest: France (59.1%).

• =

Government Revenues (Taxes)

• Four principal categories of tax receipts:

  1. Personal taxes (income/property taxes): Largest category.

  2. Social insurance contributions: Includes Social Security taxes, employer-matched.

  3. Taxes on production & imports: Primarily sales taxes.

  4. Corporate taxes: Corporate profit taxes.

Trends in Tax Revenues (% of GDP)

• Tax share in GDP:

  • 1940: 15.7%

  • 2000: 28.3%

  • 2011: 23.5%

  • 2013-2021: 25-27%

• Major shifts:

• WWII: Personal taxes jumped from 1.7% to 8.5% of GDP.

• 1964 & 1981 tax cuts: Lowered personal taxes.

• Clinton-era tax increases (1990s): Raised revenues.

• Bush-era tax cuts (2000s): Lowered revenues.

• Social insurance taxes: Increased due to higher contribution rates and income ceilings.

The Composition of Outlays and Taxes – Federal vs. State & Local Governments

Key Points on Government Spending:

Federal vs. State/Local Budgets: Federal, state, and local governments have different spending compositions.

Consumption Expenditures:

• 60%+ of state and local spending is for consumption.

• <20% of federal spending goes to consumption, mostly on national defense.

Transfer Payments:

• Federal budget prioritizes transfer payments (Social Security, Medicare, etc.).

• State and local budgets rely less on transfers.

Grants-in-Aid:

• Federal government provides grants to state/local governments for education, transportation, welfare.

• Grants account for ~⅓ of state and local revenue.

Net Interest Paid:

• Federal government pays significant interest due to high debt.

• State/local governments sometimes receive more interest than they pay.

Key Points on Government Revenue:

Federal Tax Structure:

• ~50% from personal taxes.

• ~40% from social insurance contributions.

• ~10% from corporate taxes & taxes on production/imports.

State & Local Tax Structure:

• ~45% from taxes on production & imports (sales taxes, excise taxes).

• ~18% from personal taxes.

• ~33% from federal grants.

Deficits & Surpluses:

• Total Budget Deficit: When outlays exceed tax revenues.

• Primary Deficit: Excludes net interest payments, indicating if current programs are self-sustainable.

• Current Deficit: Excludes government investment from spending.

• Government borrowing varies based on deficit type.

15.2 Government Spending, Taxes, and the Macroeconomy

Fiscal Policy & Macroeconomy: Affects output, employment, and prices through (1) aggregate demand, (2) government capital formation, and (3) incentives.

Aggregate Demand:

• Government spending shifts the IS curve, increasing demand.

• Classical View: Tax changes don't affect demand (Ricardian equivalence).

• Keynesian View: Tax cuts boost consumption, increasing demand.

• Business Cycle Debate:

  • Classicals: Against using fiscal policy to smooth cycles.

  • Keynesians: Support stabilization via spending/tax adjustments.

Challenges in Fiscal Policy:

• Inflexibility: Budget constraints (e.g., security, infrastructure, social programs) limit rapid changes.

• Time Lags: Policy implementation often takes 18+ months, making countercyclical measures ineffective.

Automatic Stabilizers:

• Reduce policy delays by adjusting taxes/spending automatically with GDP changes.

• Examples:

  • Unemployment insurance: Increases spending in recessions.

  • Income tax system: Lowers taxes in downturns, raises in booms.

Full-Employment Deficit:

• Measures the deficit excluding automatic stabilizers, focusing on legislated fiscal policy changes.

• Deficit rises in recessions, falls in booms due to automatic stabilizers.

Government Capital Formation:

• Government spending impacts both physical capital (infrastructure) and human capital (health, nutrition, education).

• Federal government investment in 2021: $360 billion (23% of federal purchases), with 55% for defense and 45% for non-defense capital.

• State/local government investment in 2021: $442.3 billion (one-sixth of state/local purchases), mainly for structures.

• Federal government focuses more on intellectual property (R&D), while state/local governments invest more in infrastructure.

Incentive Effects of Fiscal Policy:

• Tax policies influence economic behavior by changing the financial rewards of activities.

• Average tax rate: Total taxes paid divided by income; Marginal tax rate: Tax on each additional dollar earned.

• Labor Supply:

  • Increase in average tax rate (with constant marginal tax rate) leads to higher labor supply.

  • Increase in marginal tax rate (with constant average tax rate) leads to lower labor supply.

• Tax cuts in 2017 aimed to encourage economic activity but had limited long-term impact.

• Business tax reductions may incentivize investment and increase capital stock.

Tax-Induced Distortions and Tax Rate Smoothing:

• Taxes cause deviations from efficient, free-market behavior, creating economic distortions.

• Example: Higher tax rates reduce worker's incentive to work extra hours, leading to inefficiency.

• Tax rate smoothing is a strategy to minimize distortions by maintaining stable tax rates over time.

• Excessive tax rate fluctuations cause larger economic distortions.

• The U.S. WWII deficit financing through borrowing instead of high taxes exemplified tax smoothing.

15.3 Government Deficits and Debt

Budget Deficit vs. Government Debt:

• Budget Deficit: The annual difference between government spending and tax revenue (a flow variable).

• Government Debt: The total outstanding government debt (a stock variable) that accumulates over time.

• The deficit contributes to an increase in government debt.

Deficit and Debt Relationship:

• The deficit for any year equals the change in government debt for that year.

• Large deficits lead to rapid growth in government debt over time.

Historical Growth of U.S. Debt:

• U.S. federal debt grew 30 times from 1980 ($712 billion) to 2021 ($22,284 billion).

• Adjusting for inflation, the real value of debt increased more than 11-fold.

Debt-to-GDP Ratio:

• Debt-to-GDP ratio compares the total government debt to the country's GDP.

• The U.S. debt-to-GDP ratio spiked during World War II due to war spending and bonds issuance.

• Post-WWII, the ratio decreased until the 1980s, when budget deficits increased the ratio.

• Late 1990s economic growth and surpluses reduced the ratio, but the Great Recession and pandemic spending led to a rise in the ratio.

Key Drivers of Debt-to-GDP Ratio:

• High budget deficits relative to GDP.

• Slow GDP growth exacerbates the ratio increase.

Concerns over Government Debt:

• High government debt raises concerns about future financial burdens on descendants, who might face higher taxes.

• Some research links high debt relative to GDP with lower future economic growth.

Ownership of Debt:

• Historically, most U.S. debt was owned by U.S. citizens, meaning future generations would inherit both debt and its payments.

• Foreign ownership of U.S. debt (over 30% since 2001), particularly by countries like China, challenges this notion.

Potential Burdens on Future Generations:

• Higher Taxes: Future tax hikes to pay off the debt may distort economic efficiency and hurt future generations.

• Wealth Inequality: Future taxpayers, especially those with few bonds, may end up paying more in taxes than they receive, potentially shifting resources from the poor to the rich.

• National Saving Impact: Debt could lower national savings, meaning future generations inherit less capital and may pay more interest to foreigners, reducing their standard of living.

Ricardian Equivalence and Its Debate:

• What is Ricardian Equivalence?: Theory suggesting that tax cuts today are offset by expected future tax hikes, meaning no effect on national saving.

• Deficit and Tax Cuts: A tax cut now without immediate government spending increases could lead to more consumption, but Ricardian equivalence suggests future tax increases will offset this.

Ricardian Equivalence Across Generations:

• Even if the current generation receives a tax cut, future generations are expected to bear the burden of higher taxes.

• Economist Robert Barro suggests that if the current generation cares about future generations, they might save their tax cuts to offset the future tax burden (e.g., by increasing their children's inheritance).

• Therefore, the tax cut may not lead to increased consumption today, as individuals plan for future tax burdens.

• Ricardian Equivalence: The idea that tax cuts do not increase consumption because people save in anticipation of future taxes to pay for government debt.

• Disagreement Today: Less agreement on whether tax cuts increase consumption. In the 1980s, U.S. deficits didn’t match Ricardian predictions, but other countries like Canada and Israel saw Ricardian equivalence work well at times.

• Tax Cuts and Borrowing: Tax cuts may affect consumption and national saving, but the impact might be small.

Reasons Ricardian Equivalence May Fail:

1. Borrowing Constraints: People often can’t borrow enough to increase consumption, so they may take advantage of tax cuts to spend more.

1. Shortsightedness: Many people don’t consider future taxes when making consumption decisions. They may increase consumption in response to a tax cut, ignoring future tax burdens.

1. Failure to Leave Bequests: People who don’t expect to leave money to future generations may increase consumption after a tax cut, undermining Ricardian equivalence.

1. Non-Lump-Sum Taxes: Ricardian equivalence holds only for lump-sum taxes. Non-lump-sum tax changes affect economic behavior, such as consumption and saving, and may lead to real economic effects. For instance, a temporary sales tax cut could boost consumption, but other tax changes might affect savings.

Fiscal Policy During the Great Recession

During the Great Recession (2007-2009), the U.S. government implemented several fiscal policy measures aimed at stabilizing the economy. These policies were focused on addressing the immediate financial crisis and mitigating its broader economic effects.

1. The Emergency Economic Stabilization Act (EESA) of 2008

• Purpose: This was a key piece of legislation passed in October 2008, authorizing the Troubled Asset Relief Program (TARP).

• TARP: It provided $700 billion to purchase distressed assets, primarily from financial institutions, to stabilize the banking sector. This aimed to restore confidence in the financial system by addressing liquidity problems and preventing further bank failures.

2. The American Recovery and Reinvestment Act (ARRA) of 2009

• Purpose: Aimed at stimulating economic activity and creating jobs.

• Size: Approximately $831 billion in spending and tax cuts.

• Key Components:

  • Tax Cuts: Included tax rebates for individuals, cuts in payroll taxes, and incentives for businesses.

  • Government Spending: Significant investments in infrastructure, energy, health care, and education.

  • Unemployment Benefits: Extended unemployment insurance benefits and increased funding for food assistance programs.

3. Unemployment Insurance and Welfare Programs

• Expansion: The government expanded unemployment insurance and other welfare programs (e.g., food stamps), as a way to directly support individuals and families affected by the economic downturn.

• Extended Benefits: Many states extended unemployment insurance beyond the normal time limits, providing more support for jobless workers.

4. Auto Industry Bailout (2008-2009)

• Purpose: To prevent the collapse of major U.S. automakers (e.g., General Motors, Chrysler) which were heavily impacted by the recession.

• Action: The federal government provided loans and financial assistance, initially through TARP, and later through direct intervention and restructuring measures.

5. The Housing and Economic Recovery Act (HERA) of 2008

• Purpose: To address the collapse of the housing market and provide relief to homeowners.

• Key Provisions:

  • Established the Federal Housing Finance Agency (FHFA) to oversee Fannie Mae and Freddie Mac.

  • Created the Hope for Homeowners program to help struggling homeowners avoid foreclosure by refinancing their mortgages.

6. Interest Rate Cuts and Federal Reserve Actions

• Monetary Policy: While not strictly fiscal policy, the Federal Reserve played a critical role in responding to the crisis by slashing interest rates and engaging in non-conventional monetary policy, such as quantitative easing (purchasing long-term securities).

• Fiscal-Monetary Coordination: While fiscal policy aimed at direct economic stimulus, the Federal Reserve’s actions were designed to provide liquidity and keep borrowing costs low.

7. State and Local Government Stimulus

• Support: The federal government provided funding to state and local governments to help them cope with declining tax revenues and prevent cuts in essential services like education, health care, and public safety.

• Revenue Sharing: The ARRA included provisions to assist state governments in managing budget shortfalls during the recession.

8. Financial System Reforms (Dodd-Frank Act)

• Purpose: In response to the financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010, with provisions aimed at regulating the financial system to prevent future crises.

• Key Provisions:

  • Created the Consumer Financial Protection Bureau (CFPB).

  • Established regulations on financial institutions, including "too big to fail" provisions and stress tests to ensure financial stability.

15.4 Deficits and Inflation

Link Between Deficits and Inflation

• Deficits can lead to inflation if they result in excessive money supply growth.

• Inflation occurs when aggregate demand rises faster than aggregate supply.

Deficit and Aggregate Demand

• Increased government spending or tax cuts reduce national saving, increasing aggregate demand.

• This pushes the price level higher, causing inflation.

Temporary vs. Sustained Inflation

• Expansionary fiscal policies cause a one-time increase in prices.

• Sustained inflation occurs only if the money supply continues to grow.

Deficits and Money Supply Growth

• If deficits are financed by printing money, the money supply expands, causing inflation.

• Governments may use seignorage (revenue from printing money) instead of taxation or borrowing.

• Central banks buying government bonds with newly created money also increases the money supply.

Seignorage and Inflation Tax

• Seignorage is effectively an inflation tax, reducing the purchasing power of money.

• Governments mainly rely on this in extreme conditions (e.g., war, economic crises).

Real Seignorage Collection

• Inflation rate (π\pi) is directly linked to money growth rate.

• Real revenue from seignorage = inflation rate × real money supply.

• Those holding money lose purchasing power due to inflation.