1

Fiscal Policy

CHAPTER

27

© 2003 South-Western/Thomson Learning

2

Fiscal Policy

Fiscal policy refers to government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables such as real GDP, employment, the price level, and economic growth

Two categoriesAutomatic stabilizersDiscretionary fiscal policy

3

Automatic Stabilizers

Refer to revenue and spending items in the federal budget that automatically change with the ups and downs of the economy so as to stabilize disposable income and, hence, consumption and real GDP

Federal income tax• Reduces the drop in disposable income

during recessions and reduces the jump in disposable income during expansions

• Once adopted, it requires no congressional action to operate year after year

4

Discretionary Fiscal PolicyRequires ongoing congressional decisions involving the deliberate manipulation of government purchases, taxation, and transfers to promote macroeconomic goals such as full employment, price stability, and economic growth

Clinton administration tax increasesBush’s 2001 tax cut

5

Fiscal Policy

Using the income-expenditure framework, we will initially focus on the demand side to consider the effect of changes in government purchases, transfer payments, and taxes on real GDP demanded

The short story is that at any given price level, an increase in government purchases or in transfer payments increases real GDP, and an increase in net taxes decreases real GDP, other things constant

6

Government Purchases Multiplier

As long as consumption is the only spending component that varies with income, the multiplier for a change in government purchases, other things constant, equals

MPC1

1

Thus, we can say that for a given price level, and assuming that consumption varies with income

)1

1(

MPCGrealGDP

7

Change in Net Taxes

A change in net taxes also affects real GDP demanded, but the effect is less direct

SpecificallyA decrease in net taxes, other things constant, increases disposable income at each level of real GDP consumption increasesAn increase in net taxes, other things constant, reduces disposable income at each level of real GDP consumption decreases

8

Simple Tax Multiplier

The effect of a change in net taxes on real GDP demanded equals the resulting shift in the consumption function times the simple spending multiplier

Therefore, the change in real GDP can be determined as

)1

(MPC

MPCNTrealGDP

MPC

MPC

1

9

Differences Two differences between the government-purchase multiplier and the simple tax multiplier

The government-purchase multiplier is positive an increase in government purchases leads to an increase in real GDP demanded. The net tax multiplier is negative an increase in net taxes leads to a decrease in real GDP demandedThe multiplier for a given change in government purchases is larger by 1 than the absolute value of the multiplier for an identical change in net taxes

10

Differences

This latter difference occurs because changes in government purchases affect aggregate spending directly while the simple tax multiplier increases consumption indirectly by way of a change in disposable income

In short, an increase in government purchases has a greater impact than an identical tax cut because some of the tax cut is saved

11

Fiscal Policy: Contractionary Gap

What if policy makers overshoot the mark and stimulate aggregate demand more than needed to achieve potential GDP?

In the short run, real GDP will exceed potential outputIn the long run, firms and resource owners will adjust to the unexpectedly high price levelThe short-run supply curve will shift back until it intersects the aggregate demand curve at potential output, increasing the price still further but reducing real GDP to potential output

12

Problems with Fiscal PolicyPrecise expansionary and contractionary fiscal policies are difficult to achieve, for their proper execution assumes that

The relevant spending multiplier can be predicted accuratelyAggregate demand can be shifted by just the right amountThe potential level of output is accurately gaugedVarious government entities can somehow coordinate their fiscal effortsThe shape of the short-run aggregate supply curve is known and remains constant

13

Multiplier and Time Horizon

In the short run, the aggregate supply curve slopes upward a shift in aggregate demand changes both the price level and the level of output the simple multiplier overstates the amount by which output changes

The exact change in equilibrium output depends on the steepness of the aggregate supply curve, which in turn depends on how sharply production costs increase as output expands

14

Multiplier and Time Horizon

The steeper the short-run aggregate supply curve

the less impact a given shift in the aggregate demand curve has on output andthe more impact it has on the price level the smaller the spending multiplier

If the economy is already producing its potential, then, in the long run, any change in fiscal policy aimed at stimulating demand will increase the price level but will not affect output spending multiplier is zero

15

Evolution of Fiscal PolicyPrior to the Great Depression, public policy was shaped by the views of classical economists who generally believed that free markets were the best way to achieve national economic prosperity

Economists believed that natural market forces, such as changes in prices, wages, and interest rates, would correct the problems of inflation and unemployment no need for government intervention in the economy

16

Great Depression and World War II

Keynesian theory and policy were developed to address the problem of unemployment arising from the Great Depression

Keynes’s main quarrel with the classical economists was that prices and wages did not appear flexible enough to ensure the full employment of resources, e.g, they were sticky natural forces would not return the economy to full employment in a timely fashion

17

Great Depression and World War II

Keynes also believed business expectations might at times become so bleak that even very low interest rates would not spur firms to invest all that consumers might save

The Great Depression continues to influence economic thought and policy solutions

18

Great Depression and World War II

Three developments following the Great Depression bolstered the use of discretionary fiscal policy in the United States

The influence of Keynes’s General Theory in which he argued that natural forces would not necessarily close a contractionary gap government would have to increase aggregate demand so as to boost output and employmentThe demands of World War II greatly increased production and in the process eliminated cyclical unemployment during the war years

19

Great Depression and World War II

The third development, largely a consequence of the first two, was the passage of the Employment Act of 1946, which gave the federal government responsibility for promoting full employment and price stabilityThe combined impact of these factors led policy makers grew more receptive to the idea that fiscal policy could improve economic stabilityAdditionally, the objective of fiscal policy was no longer to balance the budget but to promote full employment with price stability even if deficits occurred in the process

20

Automatic Stabilizers

Automatic stabilizers smooth fluctuations in disposable income over the business cycle, thereby boosting aggregate demand during periods of recession and dampening aggregate demand during periods of expansion

Two good examples of automatic stabilizers

Progressive income taxUnemployment compensation

21

Progressive Income TaxThe progressive income tax relieves some of the inflationary pressures that might otherwise arise when output increases above its potential during an economic expansion

Conversely, when the economy is in a recession, real GDP declines but taxes decline faster, so disposable income does not fall as much as real GDP it cushions declines in disposable income, in consumption, and in aggregate demand

22

Unemployment InsuranceDuring an economic expansion, unemployment insurance taxes flow from the income stream into the insurance fund, thereby moderating aggregate demand

During a recession, unemployment payments automatically flow from the insurance fund to those who have become unemployed increasing disposable income and consumption

23

From the Golden Age to Stagflation

John F. Kennedy was the first president to propose a federal budget deficit to stimulate an economy by proposing a tax cut for the purpose of stimulating business investment, consumption, and employment

Discretionary fiscal policy is a type of demand-management policy because the objective is to increase or decrease aggregate demand to smooth fluctuations

24

From the Golden Age to Stagflation

However, the 1970s were different when the problem was stagflation the double trouble of higher inflation and higher unemployment resulting from a decrease in aggregate supply

Demand-management policies were ill suited to solving these problems because an increase in aggregate demand would worsen inflation, whereas a decrease in aggregate demand would worsen unemployment

25

Problems with Fiscal Policy

Other concerns also caused economists and policy makers to question the effectiveness of discretionary fiscal policy

The difficulty of estimating the natural rate of unemploymentThe time lags involved in implementing fiscal policyThe distinction between current and permanent incomePossible feedback effects of fiscal policy on aggregate supply

26

Natural Rate of UnemploymentThe unemployment rate that occurs when the economy is producing its potential GDP is called the natural rate of unemployment

Before adopting discretionary policies, public officials must correctly estimate this natural rate

27

Lags in Fiscal PolicyThe time required approving and implementing fiscal legislation may hamper its effectiveness and weaken discretionary fiscal policy and may in fact do more harm than good

Since a recession is not usually identified as such until at least six months after it begins, and since the eight recessions since 1949 lasted an average of 11 months, this leaves a narrow window in which to execute discretionary fiscal policy

28

Permanent IncomeThe original belief was that given the marginal propensity to consume, a relationship that is among the most stable in macroeconomics, tax changes could increase or decrease disposable income to bring about any desired change in consumption

A more recent view is that people base their consumption decisions not merely on changes in their current income but on changes in their permanent income

29

Permanent Income

Permanent income is the income a person expects to receive on average over the long run

Thus, changes in taxes that are regarded as temporary will not stimulate consumption and may render fiscal policy ineffective

30

Feedback EffectsFiscal policy may unintentionally affect aggregate supplyFor example, suppose the government increases unemployment benefits and finances these transfer payments with higher taxes on current workers. If the marginal propensity to consume is the same for both groups, the reduction in spending by those whose taxes increase should just offset the increase in spending by transfer recipients

31

Feedback EffectsThus, with a fiscal policy that focuses on aggregate demand, there should be no change in aggregate demand or on equilibrium real GDP

But what of possible effects of these changes on the labor supply?

The unemployed, who benefit from increased transfers, now have less incentive to find work

32

Feedback Effects

Conversely, workers who find their after-tax wage reduced by the higher tax rates may be less willing to work

In short, the supply of labor could decrease as a result of offsetting changes in taxes and transfers with the result that aggregate supply would decline economy’s potential GDP would decline

33

Budget Deficits of the 1980s and 1990s

The Reagan tax rate cut reflected a philosophy that reductions in tax rates would make people more willing to work and to invest because they could keep more of what they earned

Lower taxes, would increase the supply of labor and the supply of other resources thereby increasing aggregate supply and the economy’s potential GDP

34

Supply Side EconomicsThis supply-side theory held that enough additional real GDP would be generated by the tax cuts that total tax revenue would actually increase

What actually happened?

Taking 1981 to 1988 as the time frame, we can examine the effects of the 1981 federal income tax rate cut.

35

Supply Side Economics

After the tax cut was approved but before it took effect, a recession hit the economy and the unemployment rate increasedBetween 1981 and 1988 employment climbed by 15 million and real GDP per capita increased by about 2.5% per yearThe stimulus from the tax rate cut helped sustain a continued expansion during the 1980s, the longest peacetime expansion to that point in history

36

Supply Side Economics

Despite the growth in employment, government revenues did not expand to offset the combination of tax cuts and increased government spendingBetween 1981 and 1988, federal outlays grew an average of 7.1% while federal revenues averaged a 6.3% increase the deficits accumulated into a huge national debt which doubled relative to GDP from 33% in 1981 to 64% in 1992

37

Political Business Cycles

William Nordhaus developed a theory of political business cycles, arguing that incumbent presidents use expansionary policies to stimulate the economy, often only temporarily, during an election yearThat is, they try to increase their changes of reelection by pursuing policies that stimulate real GDP and reduce unemployment

38

Political Business Cycles

The evidence to support the theory of political business cycles is not entirely convincing

One problem is that the theory limits presidential motives to reelection, when in fact presidents may have other objectives

39

Political Business Cycles

An alternative to this theory, and one that is supported by some evidence, is that Democrats care relatively more about unemployment and relatively less about inflation than do Republicans

Democrats tend to pursue expansionary policies while Republicans tend to pursue contractionary policies

40

Balancing the Budget

The combination of increased taxes imposed by the Clinton administration and a vigorous recovery fueled by growing consumer spending, rising business optimism, and the strongest stock market in history led to record budget surplusesHowever, by early 2001, U.S. economic growth was slowing, so that President George W. Bush pushed through across the board tax cuts

41

Balancing the Budget

The terrorist attack on September 11, 2001 further depressed consumer confidence with the result that taxpayers spent only about one-fifth of the tax rebate checks

Thus, additional stimulus programs were put in place