Chapter 17: Government Budgets and Fiscal Policy

Chapter 17: Government Budgets and Fiscal Policy

Outline of Chapter 17

  • Government Spending: What Do We Spend On?

  • Taxation: Types of Taxes

  • Federal Deficits and the National Debt

  • Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

  • Automatic Stabilizers

  • Practical Problems with Discretionary Fiscal Policy

  • The Question of a Balanced Budget

Government Spending

  • Budget Deficit:

    • Definition: Occurs when the federal government spends more money than it receives in taxes within a given year.

  • Budget Surplus:

    • Definition: Occurs when the government receives more money in taxes than it spends during a year.

  • Balanced Budget:

    • Definition: Occurs when government spending and taxes are equal for a year.

  • Major Federal Spending Categories:

    • National Defense

    • Social Security

    • Health Programs

    • Interest Payments

Federal Spending From 1960–2020

  • The total federal spending has fluctuated between 18% and 22% of GDP.

  • The share of spending on national defense has generally declined.

  • The share allocated to Social Security and healthcare (primarily Medicare and Medicaid) has increased.

Deficit versus Debt

  • Deficit:

    • Refers to the annual budget outcome (what happens each year with the federal budget).

  • Debt:

    • Represents the accumulated total of all past deficits and surpluses over time.

Slices of Federal Spending (2019)

  • About 60% of government spending is directed towards four major areas:

    • National Defense

    • Social Security

    • Healthcare

    • Interest payments on past borrowing

  • This allocation leaves approximately 40% for all other functions of the U.S. government.

State and Local Spending (1960–2020)

  • Spending from state and local governments rose from around 10% of GDP in the early 1960s to 14–16% by the mid-1970s.

  • This level of spending has remained roughly constant since then.

  • Single Largest Spending Item: Education, including K–12 and support for public colleges and universities, accounting for about 4–5% of GDP in recent decades.

Taxation

  • Federal Tax Revenues: Typically around 17–20% of GDP in recent decades.

  • Primary Sources of Revenue:

    • Individual Income Taxes

    • Payroll Taxes (financing Social Security and Medicare)

    • Corporate Income Taxes (smaller share)

    • Social Insurance Taxes (smaller share)

Taxes Collected by the Federal Government

  • Individual Income Tax:

    • Based on all forms of income received by individuals.

  • Payroll Tax:

    • Based on wages paid by employers, funding Social Security and Medicare.

  • Corporate Income Tax:

    • Tax levied on corporate profits.

  • Excise Tax:

    • Specific goods tax (e.g., gasoline, tobacco, alcohol).

  • Estate and Gift Tax:

    • Tax on assets passed to the next generation after death or as gifts.

Tax Rates

  • Marginal Tax Rate:

    • Definition: The tax rate an individual pays on one additional dollar of income; the tax percentage on the last dollar earned.

    • Current Range: 10% to 37%.

    • Example: If an income of $35,000 results in a marginal tax rate of 15%.

    • Income brackets and tax rates:

      • $0–$9,075: 10%

      • $9,075–$36,900: 15%

      • $36,900+: 25%

Tax Structures

  • Progressive Tax: A tax system where higher-income earners pay a larger percentage of their income in taxes than lower-income earners. This is characteristic of the U.S. income tax.

  • Proportional Tax: A flat percentage of income regardless of the income level.

  • Regressive Tax: A tax system where higher-income earners pay a smaller percentage of their income in taxes compared to lower-income earners.

Revenue Sources for State and Local Governments

  • Revenue sources include:

    • Sales Taxes

    • Property Taxes

    • Revenue-sharing from federal government

    • Personal and Corporate Income Taxes

State and Local Tax Revenue as a Share of GDP (1960–2020)

  • Tax revenues have risen to keep pace with increasing state and local expenditures.

  • Most states (except Vermont) have balanced budget laws, requiring that increases in spending be matched with increases in revenue.

Federal Deficits and The National Debt

  • Annual Budget Deficit (or Surplus):

    • Difference between tax revenue and spending during a fiscal year (Oct 1 to Sept 30).

  • Fiscal Definition: Indicates the amount the government has borrowed within a specific year.

  • National Debt: Sum of all past budget deficits and surpluses that have not yet been paid back, represented by the outstanding Treasury bonds owed by the federal government.

Historical Perspective on Federal Budget Deficits and Surpluses (1929–2020)

  • Graphical representation trends display the U.S. deficits and surpluses as a percent of GDP.

  • Notable fluctuations align with U.S. recession periods indicated on the graph.

Federal Debt as a Percentage of GDP (1942–2014)

  • Federal debt results from cumulative annual budget deficits/surpluses.

  • In the 1960s and 1970s, despite running small deficits, debt/GDP ratios declined due to slower growth of debt compared to the economy's growth.

  • The debt/GDP ratio sharply increased during the 2008–2009 recession and again in 2020.

Government Spending and Taxes as a Share of GDP (1990–2014)

  • Larger government spending than taxes generates budget deficits, while the reverse generates surpluses.

  • The recession that began in late 2007 saw increased spending and lowered taxes, culminating in significant deficits for the year of 2009, a trend that was mirrored in a more extreme manner during 2020.

Using Fiscal Policy to Fight Economic Issues

  • Fiscal Policy: Government's use of spending and tax policy to influence economic activity over time.

  • Expansionary Fiscal Policy:

    • Enacts to increase aggregate demand through increased government spending or tax cuts.

  • Contractionary Fiscal Policy:

    • Enacts to decrease aggregate demand by reducing government spending or increasing taxes.

Economic Dynamics

  • A healthy economy continuously shifts aggregate supply and demand to the right from equilibrium E0 to E1 to E2, producing at potential GDP with minor inflationary increases in price level.

  • Lack of smooth demand shifts matching supply increases may lead to growth with deflation.

Expansionary Fiscal Policy Example

  • When the economy is at a recession point with equilibrium (E0) below potential GDP (Y0), an upward shift in aggregate demand (from AD0 to AD1) can elevate the economy to equilibrium E1 at potential GDP, minimizing inflationary pressure as shown in the LRAS curve.

Contractionary Fiscal Policy Example

  • If the economy is above potential GDP, high aggregate demand results in inflationary pressures. Implementing contractionary fiscal policy shifts aggregate demand from AD0 to AD1, establishing a new equilibrium at potential GDP where AD1 intersects the LRAS curve.

Automatic Stabilizers

  • Discretionary Fiscal Policy:

    • Government legislation that alters overall tax/spending levels to affect economic activity.

    • Examples include the 2009 and 2020 stimulus packages.

  • Automatic Stabilizers: Tax and spending regulations that dampen the rate of aggregate demand decreases during economic slowdowns and suppress demand increases during economic booms.

    • Examples include unemployment insurance and food stamps.

Standardized Employment Deficit or Surplus

  • Definition: The budget adjusted for what the deficit/surplus would be at potential GDP production levels, eliminating the effects of automatic stabilizers.

    • During recessions, standardized deficits are lower than actual due to the economy being below potential GDP with automatic stabilizers reducing taxes and raising spending. Conversely, when the economy performs well, the standardized deficit exceeds actual due to higher tax revenues and reduced spending needs.

Practical Problems with Discretionary Fiscal Policy

  • Crowding Out: Result of government borrowing and spending that raises interest rates, subsequently reducing business investments and household consumption.

Fiscal Policy and Interest Rates

  • Government borrowing increases financial capital demand leading to higher interest rates, making borrowing costlier for firms and consumers. This increase could counteract intended stimulation from expansionary fiscal policy.

Long and Variable Time Lags

  • Implementation of fiscal policy involves time delays:

    • Recognition Lag: Time taken to acknowledge a recession has occurred.

    • Legislative Lag: Time required to pass a fiscal policy bill.

    • Implementation Lag: Time taken for funds from fiscal policy to be allocated to relevant agencies for program implementation.

The Question of a Balanced Budget

  • Arguments for balanced budget requirement:

    • Prevents excessive government borrowing and promotes financial discipline.

  • Arguments against:

    • Economic cycles lead to fluctuating deficits and surpluses influenced by automatic stabilizers.

    • Long-term deficits through investments in human capital and infrastructure enhance productivity; such investments would be hindered by a mandated balanced budget.