Fiscal Policy Notes

16.1 What Is Fiscal Policy?

• Fiscal policy: Changes in federal government purchases, transfer payments, and taxes to achieve macroeconomic objectives.
• State taxes and spending generally do not affect national-level objectives.
• Automatic stabilizers: Government spending and taxes that automatically adjust with the business cycle (e.g., unemployment insurance).
• Discretionary fiscal policy: Intentional government actions to change spending or taxes.

Federal Government’s Share of Total Government Expenditures

• Before the Great Depression, most government spending was at the state or local level.
• Now, the federal government's share is about two-thirds to three-quarters.

Federal Purchases and Federal Expenditures as a Percentage of GDP

• Federal expenditures are higher than ever, exceeding 30% of GDP.
• A smaller proportion is allocated to government purchases of goods and services (mainly military spending).

Federal Government Expenditures, 2022

• Federal government purchases include defense spending and other expenses like FBI salaries, national park operations, and scientific research funding.
• Approximately half of federal expenditures are for transfer payments (Social Security, Medicare, unemployment insurance).
• The remainder covers grants to state and local governments for activities like crime prevention and education, and interest payments on federal debt.

Federal Government Revenue, 2022

• Most federal revenue comes from individual employment taxes: income taxes and payroll taxes for Social Security and Medicare.
• Taxes on firm profits constitute about 6.7% of federal receipts.
• The rest includes excise taxes, import tariffs, and other fees from firms and individuals.

Social Security and Medicare: Fiscal Time Bombs?

• Social Security and Medicare have reduced poverty among the elderly, while Medicaid improves health for the poor.
• Aging population and rising healthcare costs jeopardize these programs.
• The budget shortfall for these programs through 2092 is estimated at almost $16.8$ trillion in present value terms.
• Possible measures to sustain these programs:
  • Increasing taxes.
  • Decreasing benefits (potentially varying by income).
  • Decreasing eligibility (SSI age is already increasing from 65 to 67).
  • Reducing medical costs.

16.2 The Effects of Fiscal Policy on Real GDP and the Price Level

• Fiscal policy is carried out through changes in government purchases and taxes.
• Changes in government purchases directly affect aggregate demand.
• Changes in taxes affect income, which indirectly affects consumption and aggregate demand.

Expansionary Fiscal Policy

• Involves increasing government purchases or decreasing taxes.
• Used to restore long-run equilibrium by decreasing unemployment when real GDP is below potential GDP.

Contractionary Fiscal Policy

• Involves decreasing government purchases or increasing taxes.
• Used to restore long-run equilibrium by decreasing inflation when real GDP is above potential GDP.

Countercyclical Fiscal Policy

• Aims to counteract business cycle fluctuations.
• Expansionary policies (increase government purchases, cut taxes) raise real GDP and the price level during recessions.
• Contractionary policies (decrease government purchases, raise taxes) lower real GDP and the price level during rising inflation.
• Effects assume ceteris paribus, including constant monetary policy.
• Contractionary policy aims to lower inflation rather than cause prices to fall.

16.3 Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model

• Fiscal policy can be analyzed using the dynamic aggregate demand and aggregate supply model.
• This model improves understanding by accounting for changes in long-run potential GDP and price levels.

Expansionary Fiscal Policy in the Dynamic Model

• The government enacts expansionary fiscal policy to increase aggregate demand to maintain full employment.
• Results in a higher price level than without the policy.

Contractionary Fiscal Policy in the Dynamic Model

• The government enacts contractionary fiscal policy to decrease aggregate demand to maintain full employment and avoid high inflation.

16.4 The Government Purchases, Tax, and Transfer Payments Multipliers

• Government purchases multiplier reflects the multiplied effect of changes in government spending on aggregate demand and real GDP.
• Multiplier effect: A change in autonomous expenditure leads to a larger change in real GDP.

The Multiplier Effect and Aggregate Demand

• Predicting the multiplied effect requires knowing the size of the multiplier.
• Induced increase in aggregate demand occurs as increased income leads to more consumer spending.

Multipliers for Government Purchases and Taxes

• Tax multiplier: Measures the change in equilibrium real GDP due to a change in taxes; it's negative because increased taxes decrease real GDP.
• Tax multiplier is smaller in absolute value than the government purchases multiplier because a tax cut is partially saved.

The Transfer Payments Multiplier

• Transfer payments increase household disposable income, increasing consumption spending and having a positive multiplier effect.

The Effect of Changes in the Tax Rate

• Decreases in tax rates increase disposable income and the size of the multiplier effect.

The Multiplier Effect and Aggregate Supply

• An increase in aggregate demand raises real GDP and the price level (due to the upward-sloping short-run aggregate supply curve).

The Multipliers Work in Both Directions

• Increases in government purchases and cuts in taxes have positive multiplier effects.
• Decreases in government purchases and increases in taxes have negative multiplier effects.

16.5 The Limits to Using Fiscal Policy to Stabilize the Economy

• Fiscal policy may be less effective than monetary policy due to:
  • Legislative delay: Time needed for Congress to agree on actions.
  • Implementation delay: Time needed for spending projects to begin.
  • Crowding out: A decline in private expenditures due to an increase in government purchases.

Recession of 2007–2009

• The recession of 2007–2009 was the deepest since the Great Depression.
• Financial crises contribute to more severe recessions.

The Effect of Crowding Out in the Short Run

• A temporary increase in government purchases decreases the supply of loanable funds, raising the equilibrium interest rate.
• Higher interest rates reduce consumption, investment, and net exports, partially offsetting the initial spending increase.

Crowding Out in the Long Run

• In the long run, increased government purchases have no effect on real GDP as reductions in consumption, investment, and net exports offset the increase.
• The economy returns to potential GDP without government intervention.
• The long-run effect is to increase the size of the government sector.
• The intermediate increase in real GDP may be worth the cost.

Fiscal Policy in Action: Did the Stimulus Package of 2009 Succeed?

• A tax cut in early 2008 provided a one-time rebate of taxes paid, totaling $95$ billion.
• Changes to current incomes result in smaller spending increases compared to permanent incomes due to consumption smoothing.
• Consumers spent about 33–40% of the rebates, resulting in approximately $35$ billion in increased spending.

American Recovery and Reinvestment Act of 2009

• The stimulus package, a $840$ billion program, was the largest fiscal policy action in U.S. history.
• About two-thirds of the stimulus package involved spending increases, peaking in 2010 but continuing through 2013.
• The remainder comprised individual tax cuts and tax credits, with effects mostly in 2009–2011.

How Effective Was the Stimulus Package?

• It's difficult to isolate the effects of the stimulus package due to the influence of other factors on real GDP and employment.
• Estimates from the nonpartisan Congressional Budget Office (CBO) are often used due to its neutral politics and access to government data.

CBO Estimates of the Effects of the Stimulus Package

• The stimulus package reduced the severity of the recession but did not restore the economy to full employment.

Estimates of the Sizes of Government Purchases and Tax Multiplier

• Estimating multipliers is difficult because many factors affect aggregate demand and short-run aggregate supply simultaneously.

16.6 Deficits, Surpluses, and Federal Government Debt

• Budget deficit: Government expenditures exceed tax revenue.
• Budget surplus: Government expenditures are less than tax revenue.

The Federal Budget Deficit, 1901–2023

• The U.S. federal government generally does not balance its budget, especially during wartime and recessions.
• Automatic stabilizers limit the severity of recessions.

How the Federal Budget Can Serve as an Automatic Stabilizer

• The cyclically adjusted budget deficit or surplus is the deficit or surplus if the economy were at potential GDP.

Should the Federal Budget Be Balanced?

• Most economists believe the federal budget should be balanced when the economy is at potential GDP but not necessarily during a recession.

The Federal Government Debt, 1790–2022

• When the federal government runs a deficit, it sells Treasury securities, contributing to the federal government debt or national debt.

Who Owns the National Debt?

• Almost 40% is held by the government itself (intragovernmental holdings).
• The Fed holds large amounts of Treasury debt.
• U.S. banks and other American investors hold almost 40% of the national debt.
• The remaining 23% is held by foreign central banks, foreign commercial banks, and foreign investors.

Is Government Debt a Problem?

• The federal government is at no serious risk of defaulting due to low borrowing rates and manageable interest payments.
• A debt that increases relative to GDP can crowd out investment, hindering long-term growth, unless used for infrastructure, education, or R&D.

Should We Stop Worrying and Love the Debt?

• Modern monetary theory (MMT) suggests debt is unimportant because the government can print money to cover interest payments.
• Mainstream economists warn this approach will bring high inflation.

16.7 Long-Run Fiscal Policy and Economic Growth

• Fiscal policy aims to have long-run impacts on potential GDP (aggregate supply).
• These actions are referred to as supply-side economics, often based on changing taxes to increase incentives to work, save, invest, and start a business.

Explaining Long-Run Increases in Real GDP

• The long-run growth rate of real GDP depends primarily on:
  • The growth in the number of hours worked
  • The growth rate of labor productivity
• $Growth \ rate \ of \ real \ GDP = Growth \ rate \ of \ hours \ worked + Growth \ rate \ of \ labor \ productivity$

The Basis for the CBO’s Estimate of Real GDP Growth, 2023–2053

• The CBO predicts hours worked will grow slower than the population, so the majority of real GDP growth will result from increasing productivity.

The Long-Run Effects of Tax Policy

• A tax wedge, the difference between pretax and posttax return, distorts incentives, lowering economic activity.

Tax Rates Matter

• Marginal tax rates affect behavior responses to the tax:
  • Individual income tax affects labor supply decisions and returns to entrepreneurship.
  • Corporate income tax affects firm investment incentives.
  • Tax on dividends and capital gains affects the supply of loanable funds and real interest rate.

Tax Simplification

• Simpler taxes lead to economic gains.
• A simplified tax code increases economic efficiency by reducing decisions made solely to reduce tax payments.

The Supply-Side Effects of a Tax Change

• Tax reform can significantly increase real GDP in the long run.

Online Appendix: A Closer Look at the Multiplier

• Objective: Develop an econometric model for real GDP determination to identify:
  • Government purchases and tax multipliers
  • How those multipliers are altered by tax rates
  • How those multipliers change in an open economy
• Assume price levels do not change.

Finding Real Equilibrium GDP

• Assumptions: taxes do not depend on income, no government transfers, and closed economy.
• The following equations describe the model:
  • Consumption function: $C = 1,000 + 0.75Y_d$
  • Planned investment function: $I = 500$
  • Government purchases function: $G = 600$
  • Tax function: $T = 500$
  • Equilibrium condition: $Y = C + I + G$
• $Y_d$ is disposable income.
• With substitution, real GDP equals $20,000$.

A More General Approach

• More generally, model parameters can be represented by letters:
  • Consumption function: $C = C<em>0 + MPC * Y</em>d$
  • Planned investment function: $I = I_0$
  • Government purchases function: $G = G_0$
  • Tax function: $T = T_0$
  • Equilibrium condition: $Y = C + I + G$
• Equilibrium is given by: $\Delta Y = (\Delta C + \Delta I + \Delta G)$

A Formula for the Government Purchases Multiplier

• If consumption, taxes, and investment remain constant, their changes are zero; so we get:
• $Government \ Purchases \ Multiplier = \frac{1}{1-MPC}$
• With $MPC = 0.75$, the multiplier is 4.

A Formula for the Tax Multiplier

• If consumption, investment, and government purchases remain constant, their changes are zero; so we get:
• $Tax \ Multiplier = \frac{-MPC}{1-MPC}$
• With $MPC = 0.75$, the tax multiplier is -3.

The “Balanced Budget” Multiplier

• Increase government spending and taxes both by $10$ billion; what would happen to real GDP?
• $Overall \Delta Y = \frac{\Delta G - MPC * \Delta T}{1-MPC}$
• If we raise government purchases and taxes both by $10$ billion, GDP goes up by $10$ billion in the short run.
• The long-run effect is still zero; in the long run, GDP is determined by potential GDP instead.

Incorporating Tax Rates

• Model where taxes depend on income.
• Assuming a tax rate of t, consumers will now have disposable incomes of
• $Yd = Y - tY = (1-t)Y$
• The consumption function changes to:
• $C = C_0 + MPC(1-t)Y$
• $Y = \frac{1}{1-MPC(1-t)}(C<em>0 + I</em>0 + G_0)$
• If $MPC = 0.75$ and $t = 0.2$, we obtain:
• $\frac{1}{1-0.75(1-0.2)} = 2.17$
• If $MPC = 0.75$ and $t = 0.1$, we obtain:
• $\frac{1}{1-0.75(1-0.1)} = 2.35$
• So, lower tax rates lead to larger multipliers.

The Multiplier in an Open Economy

• Model includes imports and exports, where exports are autonomous, and imports depend on income.
• MPI is the marginal propensity to import: the fraction of an increase in income spent on imports.
• Equilibrium condition becomes:
• $Y = C + I + G + X - M$
• Where M is imports:
• $M = MPI \cdot Y$
• $\frac{\Delta Y}{\Delta G} = \frac{1}{1-MPC(1-t) + MPI}$
• Let $MPC = 0.75$, $t = 0.2$, $MPI = 0.1$; then
• $\frac{1}{1-0.75(1-0.2)+0.1} = 1.92$
• This is smaller than before; a portion of spending goes on imports, which do not feed back into higher domestic income.
• If MPI increases to 0.2, we have
• $\frac{1}{1-0.75(1-0.2)+0.2} = 1.67$
• So, a greater propensity to spend on imports results in a smaller government purchases multiplier.