• Fiscal policy: changes in taxes and spending that affect the level of GDP

10.1 The Role of Fiscal Policy

Fiscal Policy and Aggregate Demand

• Changes in taxes affect aggregate demand indirectly.

• Government policies that increase aggregate demand are called expansionary policies such as increasing government spending and cutting taxes.

• The government can also use fiscal policy to decrease GDP if the economy is operating at too high a level of output, which would lead to an overheating economy and rising prices.

• Government policies that decrease aggregate demand are called contractionary policies such as decreasing government spending and increasing taxes.

The Fiscal Multiplier

• The multiplier effect occurs because an initial change in output will affect the income of households and thus change consumer spending.

• As the government develops policies to stabilize the economy, it needs to take the multiplier into account.

The Limits to Stabilization Policy

• Both expansionary and contractionary policies are examples of stabilization policies, actions to move the economy closer to full employment or potential output.

• It is very difficult to implement stabilization policies for two big reasons:

  1. Lags, or delays, in stabilization policy. Lags arise because decision-makers are often slow to recognize and respond to changes in the economy, and fiscal policies and other stabilization policies take time to operate.

     1. Inside lags refer to the time it takes to formulate a policy. They occur for two reasons which are that it takes time to identify and recognize a problem, and once a problem has been diagnosed, it still takes time before the government can take action.

     2. Outside lags refer to the time it takes for the policy to actually work.

  • Economists use econometric models to replicate the behavior of the economy mathematically and statistically to assist them in developing economic forecasts.

  1. Economists simply do not know enough about all aspects of the economy to be completely accurate in all their forecasts. The difficulties of forecasting the precise behavior of human beings, who can change their minds or sometimes act irrationally, place limits on our forecasting ability.

10.2 The Federal Budget

• The federal budget is the document that describes what the federal government spends and how it pays for that spending.

• It provides the framework for fiscal policy.

Federal Spending

• Federal spending, spending by the U.S. government, consists of two broad components:

  1. Federal government purchases of goods and services

  2. Transfer payments

• Discretionary spending constitutes all the programs that Congress authorizes on an annual basis that are not automatically funded by prior laws which includes defense spending and all nondefense domestic spending.

• Entitlement and mandatory spending constitutes all spending that Congress has authorized by prior law.

• Social Security provides retirement payments to retirees as well as a host of other benefits to widows and families of disabled workers.

• Medicare provides health care to all individuals once they reach the age of 65.

• Medicaid provides health care to the poor, in conjunction with the states.

• Net interest is the interest the government pays on the government debt held by the public.

Federal Revenues

• The federal government receives its revenues from taxes levied on both individuals and businesses.

• The single largest component of federal revenue is the familiar individual income tax.

• During the year, the federal government collects in advance some of the taxes due by withholding a portion of workers’ paychecks.

• The second-largest component of federal revenue is social insurance taxes, which are taxes levied on earnings to pay for Social Security and Medicare.

• Other taxes paid directly by individuals and families include estate and gift taxes, excise taxes, and custom duties.

• The corporate tax is a tax levied on the earnings of corporations.

• Federal excise taxes are taxes levied on the sale of certain products, for example, gasoline, tires, firearms, alcohol, and tobacco.

• Customs duties are taxes levied on goods imported to the United States, such as foreign cars or wines.

• Supply-side economics is a school of thought that emphasizes the role taxes play in the supply of output in the economy.

• Laffer curve: A relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged.

The Federal Deficit and Fiscal Policy

• The federal government runs a budget deficit when it spends more than it receives in tax revenues in a given year.

• A government bond is an IOU in which the government promises to later back the money lent to it, with interest.

• If the government collects more in taxes than it wishes to spend in a given year, it is running a budget surplus. The government has excess funds and can buy back bonds it previously sold to the public, eliminating some of its debt.

Automatic Stabilizers

• The deficit serves a valuable role in stabilizing the economy through three channels:

  1. Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income.

  2. Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income.

  3. Because the corporation tax depends on corporate profits and profits fall in a recession, taxes on businesses also fall

• Automatic stabilizers: Taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action.

Are Deficits Bad?

• During a recession, we should focus on what our fiscal policy actions do to the economy, not what they do to the deficit.

• If the government cuts taxes, consumer spending will increase. However, because output is fixed at full employment, some other component of output must be reduced, or crowded out.

• Crowding out is an example of the principle of opportunity cost, the opportunity cost of something is what you sacrifice to get it.

• In the financial markets, the government will be in increased competition with businesses that are trying to raise funds from the public to finance their investment plans, too.

• This will be more difficult and costly for businesses to raise funds and lead to investment spending will decrease.

10.3 Fiscal Policy in U.S. History

The Depression Era

• During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits. According to Brown, fiscal policy was expansionary only during 2 years of the Great Depression, 1931 and 1936.

The Kennedy Administration

• It was not until the presidency of John F. Kennedy during the early 1960s that modern fiscal policy came to be accepted.

• Two factors lead to its support:

  1. Tax rates were extremely high at the time

  2. Heller convinced Kennedy that even if a tax cut led to a federal budget deficit, it was not a problem.

The Vietnam War

• Permanent Income: An estimate of a household's long-run average level of income.

• During the 1970s, there were many changes in taxes and spending but no major changes in overall fiscal policy.