Fiscal Policy Notes

The Budget and Fiscal Policy

  • Definition of the Budget:

    • Financial representation of government priorities reflecting historical debates and competing economic philosophies.

Fiscal Policy

  • Policy Tools for Managing the Economy:

    • Fiscal Policy: Decided by Congress and the President.

    • Monetary Policy: Conducted by policymakers at the Federal Reserve.

  • Focus:

    • Fiscal policy specifically examines how federal government taxing and spending affects aggregate demand.

  • Definition of Fiscal Policy:

    • Changes in federal government spending or tax rates for the purpose of influencing the macroeconomy.

Government Spending

  • Coverage:

    • Involves a range of services provided by the federal, state, and local governments.

  • Budget Definitions:

    • Budget Deficit: When the federal government spends more money than it receives in taxes in a given year.

    • Budget Surplus: When the government receives more money in taxes than it spends within a year.

    • Balanced Budget: When government spending and taxes are equal.

  • Comparison Over Time:

    • Nominal dollar comparison misleading due to inflation, population growth, and real economic growth; use government spending as a percentage of GDP for a clearer comparison.

  • Major Federal Spending Categories:

    • National Defense

    • Social Security

    • Health Programs

    • Interest Payments

    • These categories account for roughly 71% of federal spending, while the remaining 29% covers various other expenditures (e.g., education, law enforcement).

  • Financing Budget Deficits:

    • Government borrows funds by selling securities (Treasury bonds, notes, bills), promising to repay with interest.

State and Local Government Spending

  • Balanced Budget Laws:

    • All states (except Vermont) are required to close any gaps between revenues and spending.

  • Increase in Spending:

    • State and local government spending grew from about 10% of GDP in the early 1960s to 14–16% by the mid-1970s.

  • Education Spending:

    • The largest single spending item, covering K-12 education and public colleges, around 4-5% of GDP.

Taxation

Federal Taxes

  • Revenue Context:

    • Federal tax revenues approximately 17–20% of GDP in recent decades.

  • Primary Sources of Federal Taxes:

    • Individual income taxes

    • Payroll taxes (finance Social Security and Medicare)

    • Corporate income taxes

    • Excise taxes

Major Categories of Federal Taxes:

  1. Personal Income Taxes:

    • Largest single source of federal revenue, but under half of total revenue.

  2. Payroll Tax:

    • Second largest revenue source, funds Social Security and Medicare.

  3. Corporate Income Tax:

    • Represents profits of corporations — third-largest source of revenue.

Tax Types and Structures

  • Marginal Tax Rates:

    • Related to tax brackets; progressive taxes increase rates as income increases.

  • Progressive Tax:

    • Higher marginal rate for higher incomes, based on the ability to pay principle.

  • Benefit Principle:

    • Taxpayers should pay based on benefits received from public goods; equal benefits lead to equal taxes.

  • Payroll Taxes:

    • Split between employers and employees but effectively paid by employees.

  • Types of Tax Systems:

    • Proportional Tax: Constant percentage regardless of income level.

    • Regressive Tax: Lower marginal rates as income rises (e.g., Social Security tax above wage limit).

Tax Instruments

  • Excise Tax: Tax on specific goods (gasoline, tobacco).

  • Estate and Gift Tax: On large transfers of wealth.

  • Property Taxes: Based on real estate value.

  • Sales Taxes: Regarded as regressive taxes on purchases.

Federal Budgets and National Debt

  • Budget Surplus and Deficit:

    • Surplus: Line above horizontal axis.

    • Deficit: Line below horizontal axis.

  • Difference Between Debt and Deficit:

    • National Debt: Total amount borrowed over time.

    • Budget Deficit: Amount borrowed in a given year.

Economic Trends in Budgeting

  • 1990s Decline in Government Spending:

    • Key reasons are reduction in defense spending and interest payments as a percentage of GDP.

Automatic Stabilizers

  • Definition:

    • Programs that automatically modify fiscal positions—accepting increased spending during downturns without further legislation.

  • Automatic Stabilizer Examples:

    • Unemployment insurance

    • Food stamps

    • Taxation related to income.

Discretionary vs. Automatic Fiscal Policy

  • Discretionary Fiscal Policy:

    • Laws explicitly changing tax rates or spending levels.

  • Automatic Stabilizers:

    • Change without new laws to adjust to economic conditions.

Expansionary and Contractionary Fiscal Policy

  • Expansionary Fiscal Policy:

    • Increase in government spending or tax cuts to boost aggregate demand.

  • Contractionary Fiscal Policy:

    • Cuts in spending or increases in taxes to reduce aggregate demand.

Crowding Out Effect

  • Definition:

    • Government spending and borrowing can lead to higher interest rates, which reduce private sector investment.

  • Public Investments Can Help:

    • Investments in infrastructure can create conditions beneficial for private investments and economic growth.

Fiscal Policy and Economic Growth

  • Investment Areas of Focus:

    • Physical capital

    • Human capital

    • New technology

  • Government Role:

    • Encourage investments through research, development initiatives; support education to ensure long-term economic growth.

Summary of Fiscal Policy Implications

  • Focus:

    • Governments utilize fiscal policy through adjustments in spending and tax rates to stimulate the economy or slow it down.

  • Key Areas of Expenditure:

    • National defense, education, and social security are major spending areas.

  • Fiscally Responsible Approaches:

    • Need for balance to prevent long-term deficits that crowd out private investments.