Fiscal Policy Notes

Fiscal Policy

Definition and Objectives

• Fiscal policy involves using the federal budget to achieve macroeconomic goals.
• These goals include:
  • Full employment
  • Sustained economic growth
  • Price level stability
• It utilizes government revenue and expenditures to influence macroeconomic variables.
• Fiscal policy emerged in response to the Great Depression of the 1930s, rendering the laissez-faire approach ineffective.
• The term originates from the Latin word "fiscus," meaning "state treasury."

Keynesian Economics Foundation

• Fiscal policy is rooted in the theories of John Maynard Keynes.
• Keynesian economics posits that government adjustments in taxation and spending impact aggregate demand and economic activity.
• Fiscal and monetary policies are essential tools for governments and central banks to achieve economic objectives.

Government Budget

• The government budget is instrumental in achieving macroeconomic objectives.
• Tax revenues can be greater than, equal to, or less than outlays, resulting in a budget surplus, balance, or deficit.
• Budget deficits lead to government debt accumulation.

Federal Budget

• The federal budget is an annual report of the federal government's outlays and tax revenues.
• It serves two primary purposes:
  1. Financing federal government programs and activities.
  2. Achieving macroeconomic objectives.

Institutions and Laws

• The President and Congress are responsible for formulating fiscal policy.
• Fiscal policy is conducted within the framework of the Employment Act of 1946.
• The Employment Act of 1946 establishes the federal government's responsibility to:
  • Coordinate and utilize its plans, functions, and resources.
  • Promote maximum employment, production, and purchasing power.

Components of the Federal Budget

• Receipts (Revenue Sources):
  • Personal income taxes (largest source)
  • Social Security taxes
  • Corporate income taxes
  • Indirect taxes
• Outlays (Expenditures):
  • Transfer payments (largest item)
  • Expenditure on goods and services
  • Debt interest

Budget Balance

• Budget balance is the difference between receipts and outlays.
• Budget Surplus: Receipts exceed outlays.
• Budget Deficit: Outlays exceed receipts.
• Balanced Budget: Receipts equal outlays.
• Historically, the U.S. budget has been in a persistent deficit, except for a few years around 2000.
• Receipts as a percentage of GDP have remained relatively stable without a clear trend.

Budget Balance and Debt

• Government debt is the cumulative amount the government has borrowed, representing the sum of past deficits minus past surpluses.

State and Local Budgets

• The total government sector includes both state and local governments, in addition to the federal government.
• In Fiscal Year 2015:
  • Federal government outlays were approximately $4,158$ billion.
  • State and local outlays totaled $2,700$ billion.
• State expenditures primarily cover:
  • Public schools, colleges, and universities ($550$ billion).
  • Local police and fire services.
  • Roads.

Supply-Side Effects of Fiscal Policy

• Fiscal policy significantly impacts employment, potential GDP, and aggregate supply.
• Income taxes can alter full employment and potential GDP.
• Taxes can reduce the incentive to work, leading to decreased employment and potential GDP.

Tax Wedge

• Fiscal policy affects the incentive to save and invest, influencing the growth rate of real GDP.
• The Laffer curve illustrates the relationship between the tax rate and tax revenue collected.
• High income taxes may discourage employees from working as much or seeking alternative ways to retain more income, potentially through government benefits.
• Increased applications for government benefits can strain the workforce, leading to demands for higher salaries and decreased hiring rates.
• A tax wedge is the difference between before-tax and after-tax wages.
• It measures the government's revenue from taxing the labor force.
• It can also refer to market inefficiency due to taxes on goods or services, causing shifts in supply and demand equilibrium and creating deadweight losses.
• Taxes on consumption expenditure add to the tax wedge by raising prices for goods and services, equivalent to a cut in the real wage rate.
• Example: If the income tax rate is $25$% and the consumption expenditure tax rate is $10$%, a dollar earned buys only $65$ cents worth of goods and services. The tax wedge is $35$% ($25$% + $10$%).

Taxes, Savings, and Investment

• Taxes on capital income reduce saving and investment, slowing real GDP growth.
• The real after-tax interest rate influences saving and investment, calculated by subtracting income tax on interest income from the real interest rate.
• Taxes depend on the nominal interest rate, making the true tax on interest income dependent on the inflation rate.

Laffer Curve

• The Laffer curve illustrates the relationship between the tax rate and tax revenue collected.
• At tax rate T*, tax revenue is maximized.
• For a tax rate below T*, an increase in the tax rate increases tax revenue.
• For a tax rate above T*, an increase in the tax rate decreases tax revenue.

Generational Effects

• In June 2014, the United States had a net debt to the rest of the world of $11.7$ trillion.
• Of that debt, $5.8$ trillion was U.S. government debt.
• U.S. corporations used $8.6$ trillion of foreign funds.

Fiscal Stimulus

• Fiscal stimulus involves using fiscal policy to boost production and employment.
• It can be automatic (mandatory) or discretionary.
• Automatic fiscal policy is triggered by the state of the economy without government intervention.
• Discretionary fiscal policy is initiated by an act of Congress.

Automatic Fiscal Policy

• Two government budget items change automatically with the economy:
  • Tax revenues
  • Needs-tested spending
• Congress sets tax rates, but actual tax dollars depend on tax rates and incomes, which vary with real GDP.
• In an expansion, real GDP and tax revenues increase.
• In a recession, real GDP and tax revenues decrease.

Transfer Payments

• The government provides benefits to qualified individuals and businesses through transfer payment programs.
• These payments depend on the economic state.
• In an expansion, unemployment falls, and needs-tested spending decreases.
• In a recession, unemployment rises, and needs-tested spending increases.
• In a recession, receipts decrease, and outlays increase, providing an automatic stimulus to mitigate the recessionary gap.
• In a boom, receipts increase, and outlays decrease, providing automatic restraint to reduce the inflationary gap.

Discretionary Fiscal Stimulus

• Most discretionary fiscal stimulus focuses on influencing aggregate demand.
• Changes in government expenditure and taxes affect aggregate demand through multiplier effects.
• Key fiscal multipliers include:
  • Government expenditure multiplier
  • Tax multiplier

Government Expenditure Multiplier

• The government expenditure multiplier quantifies the effect of changes in government expenditure on real GDP.
• Increased government expenditure increases real GDP, leading to higher incomes and increased consumption expenditure, thus increasing aggregate demand.
• However, increased government expenditure leads to increased government borrowing and higher real interest rates.
• Higher borrowing costs decrease investment, partially offsetting the increase in government expenditure.
• The consensus is that the crowding-out effect dominates, resulting in a multiplier of less than 1.

Tax Multiplier

• The tax multiplier quantifies the effect of changes in taxes on aggregate demand.
• The demand-side effects of a tax cut are generally smaller than an equivalent increase in government expenditure.

Fiscal Stimulus and Aggregate Supply

• Taxes create a wedge between the cost of labor and take-home pay and between borrowing costs and lending returns.
• Taxes reduce employment, saving, and investment, decreasing real GDP and its growth rate.
• A tax cut mitigates these negative effects and increases real GDP and its growth rate.
• The supply-side effects of a tax cut may outweigh the demand-side effects, making the tax multiplier larger than the government expenditure multiplier.

Limitations of Fiscal Stimulus

• Fiscal policy can be automatic or discretionary.
• Automatic fiscal policy helps moderate the business cycle.
• Discretionary fiscal stimulus impacts aggregate demand and aggregate supply.
• Discretionary changes in government expenditure or taxes have multiplier effects of uncertain magnitude.
• Fiscal stimulus policies face challenges due to:
  • Uncertainty about multipliers
  • Time lags in lawmaking
  • Difficulty in accurately diagnosing and forecasting the state of the economy