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Fiscal Policy

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Fiscal Policy Defined

The government’s

(Congress and the President)

use of taxing and spending to promote economic growth and

stability

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History of Fiscal Policy

Laissez-faire (classical economics)

The Great Depression 1929 – 1930’s

WWII1939 - 1945

•No need for government interference•Market regulates itself•Adam Smith, David Ricardo, Thomas Malthus are classical economists

•Challenged classical economics•FDR increased government spending on programs to increase employment on public works to help stop the depression

•To prepare for war, U.S. increased production of war goods.•Government spending increased dramatically which helped the country out of the depression.

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History of Fiscal Policy

1960’s 1980’s

•JFK proposed tax cuts to personal and business income taxes to increase aggregate demand.•Government spending increased due to the Vietnam War.

•Reagan passed a bill to reduce taxes by 25% over 3 years to fight stagflation (high unemployment + high inflation).•Demand-side policies would not work, thus supply-side policies were introduced – known as Reaganomics.

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Two Branches of Fiscal Policy:

1. Demand-side

2. Supply-side

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Demand-Side Economics Inspired by John Maynard Keynes during the Great Depression and is also called Keynesian Fiscal Policy

Looks at changing aggregate demand which is either increasing or decreasing

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Tools of Fiscal Policy

1. Taxing Policy of Government

2. Spending Policy of Government

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Aggregate Demand isC + I + G + (F) = GDP

Changes in business (I) spending is the most volatile and this will

cause the most economic instability.

To offset this, the government can compensate by changing their

taxing and spending to maintain a stable level of GDP.

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Demand-Side Fiscal Policy

Keynes said that sometimes the market could not correct itself and the government needs to take a more active role in the economy.

This increased role of government in the economy was something different from the classical view. It was considered very radical for the time.

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Limitations of Demand-Side Fiscal Policy

1. Not coordinated with monetary policy

2. Surplus budget unpopular and politicians lack the political will to carry it out

3. Time lags - inside lags and outside lags

4. People are unpredictable. Economics is a social science so we are dealing with human behavior.

5. Doesn’t solve stagflation

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Multiplier Effect• The multiplier effect in fiscal policy

states that for every one dollar change in taxing or government spending, it will create a greater change in the national income, either increasing or decreasing.

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Fiscal Policy – Supply-Side

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Supply-Side Fiscal Policy• Economic policies designed to

stimulate output (GDP) and lower unemployment. To achieve this you increase aggregate supply (AS).

• Contemporary supply-side was implemented in the 1980’s to deal with stagflation and is sometimes called “Reaganomics.”

• Goal is to give incentives to businesses to produce more ( AS).

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Principles of Supply Side1. Tax cuts encourage consumers to

save so businesses have money to borrow for capital investment.

2. Government spending cuts especially on transfer payments where nothing is produced

3. Deregulate business

Overall Less Government© 2010, TESCCC

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When AS increases - increase GDP

PL

Q

AD

AS1 AS2

Q1

GDP

Q2

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When AS increases - price goes down

PL

Q

AD

AS1 AS2

P1

P2

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Supply-Side Economics

• Stresses the influence of taxation on the economy. Supply-siders believe that taxes have a strong, negative influence on output.

• Arthur Laffer came up with a theory concerning tax rates and tax revenues. It was called the Laffer Curve. Laffer said if you lower the tax rate, we will see an increase in tax revenue.

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Laffer Curve

Tax

R a t es

100%

0%Tax Revenues

A

E

B

D

C

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Laffer Curve

Tax

R a t es

100%

0%

Tax Revenues

Govt. will collect no revenue at two tax rates, 0% and 100%.

With 100% tax rate, workers lose all incentive to work (no disposable personal income) and at 0% tax rate the government will collect 0 revenue.

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Laffer Curve

Tax

R a t es

100%

0%Tax Revenues

A

E

B

D

C

As we move from A to B, tax rate is lowered and we increase tax revenue.

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Tax

R a t es

100%

0%

Tax Revenues

C

Point C is the optimum tax rate. Higher tax rates decrease worker incentives.

Below C we decrease the revenue.

PROBLEM: We don’t know where we are on the curve.

Laffer Curve

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Limitations

1. Lack of experience - hasn’t been around long enough

2. Don’t know where we are on Laffer Curve

3. Makes Federal Income Tax less progressive and reduces the automatic stabilization and reduces many “safety net” programs

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DECIDING FISCAL POLICYTaxing & Spending

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When the U.S. Government decides Fiscal

Policy:• They are deciding which goal to

address at a given time – economic growth, stability or full employment.

• They must decide to tax or spend to address the problems in the economy.

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Taxation

• Power to Tax – Article 1, Section 8, Clause 1 of the U.S. Constitution

• 16th Amendment• Limitations:

– Purpose is for “the common defense and general welfare”

– Federal taxes must be the same in every state

– Government may not tax exports© 2010, TESCCC

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Purposes of Taxation

• Raise revenue• Regulate the economy (fiscal policy)• Redistribution of income (transfer

payments)• Provide positive economic

incentives• Provide negative economic

incentives© 2010, TESCCC

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Types of Taxes or Tax Structures

• Progressive - takes larger percent of income from higher income groups - as income goes up tax rate increases

• example- Federal Income Tax

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Types - Regressive

• Regressive - takes larger percent of income from the lower income group

• Example - sales tax, property tax, Social Security tax

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Types - Proportional

• Proportional - takes the same percent of income from all income levels

• Examples - some state income taxes & proposed flat tax

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Principles of Taxation

1. Benefits received - people who

directly benefit or use the good

or service should pay• Example - Excise tax on

gasoline used to build roads

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2. Ability-to-pay - people who

have more wealth or income

should pay more• Example - Federal Income Tax

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Top Federal Taxes

• Individual Income Tax• Social Security• Corporate Income Tax

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Federal Taxes

0%5%

10%15%20%25%30%35%40%45%50%

Ind. Income Tax

Corp. IncomeTaxSocial Security

Excise Taxes

Estate & gift

Customs

Other

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FICA

• FICA=Social Security + Medicare

• FICA Taxable Wage Base or a cap - a maximum income level that can be taxed. All income above that level is not taxed for FICA, tax free.

• Employers match employee contributions.

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State Taxes• States receive most of their

revenue from a sales tax.

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Local Taxes

• Property Tax

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Who Bears the Burden of a Tax?

To fully evaluate the fairness of a tax, it is important to think about who bears the final burden of the tax or the incidence of a tax.

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Government Spending

• Goods and Services• Transfer Payments

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