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15 FISCAL POLICY**

* * This is Chapter 31 in Economics.

C h a p t e r K e y I d e a s

Balancing Acts on Capitol Hill

A. In 2004, the federal government planned to collect in taxes 17.3 cents of every dollar earned in the United States and at the same time to spend 20 cents of every dollar earned. How does that affect the economy?

B. For most of the 1980s and 1990s, the government ran deficits, to the extent that the national debt is now about $13,000 per person. What are its effects, and how can deficits be avoided?

O u t l i n e

I. The Federal Budget

A. The federal budget is the annual statement of the U.S. federal government’s expenditures and tax revenues together with the laws and regulations that approve and support those expenditures. Fiscal policy is the use of the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability.

B. The Institutions and Laws

1. Fiscal policy is made by the president and Congress. Figure 15.1 illustrates the timeline.

2. Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work “to promote maximum employment, production, and purchasing power.”

C h a p t e r

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3. The President’s Council of Economic Advisers monitors the economy and keeps the President and the public well informed about the current state of the economy and the best available forecast of where it is heading.

C. Highlights of the 2004 Budget

1. Tax revenues come from personal income taxes, social security taxes, corporate income taxes, and indirect taxes. Personal income taxes followed by social security taxes are the two largest revenue sources.

2. Expenditures are classified as transfer payments, purchases of goods and services, and debt interest. Transfer payments are by far the largest expenditure, and are sources of persistent growth in expenditures.

3. The federal government’s budget balance equals tax revenues minus expenditures.

a) If tax revenues exceed expenditures, the government has a budget surplus.

b) If expenditures exceed tax revenues, the government has a budget deficit.

c) If tax revenues equal expenditures, the government has a balanced budget.

D. The Budget in Historical Perspective

1. Figure 15.2 shows the government’s tax revenues, expenditures, and budget surplus or deficit as a percentage of GDP for the period 1980–2004. The government had a deficit of 5.2 percent in 1983. The deficit declined and in 1998 to 2001, the government had a surplus. A deficit emerged again in 2002 as expenditure on security increased and taxes were cut.

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2. Figure 15.3 shows the evolution of the components of tax revenues and expenditures as a percentage of GDP over the period 1980–2004. Tax revenues increased and expenditures decreased for most of the period.

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3. Government debt is the total amount that the government has borrowed. It is the sum of past budget deficits minus past budget surpluses. Figure 15.4 shows the evolution of the debt as a percentage of GDP since 1940.

4. The debt to GDP ratio reached a peak at the end of World War II in 1945. It then generally fell until 1974. From 1974 to 1992 the ratio rose; it then fell from 1992 to 2002, when it started to increase again.

E. The U.S. Government Budget in Global Perspective

1. Figure 15.5 compares government budget deficits around the world in 2003.

2. The world as a whole that year had a government budget deficit of about 3.1 percent of world GDP.

F. State and Local Budgets

1. In 2002, when the federal government spent $2,000 billion, state and local governments spent about $1,900 billion, mostly on education, protective services, and roads.

2. State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.

II. The Supply Side: Employment and Potential GDP

A. The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects.

B. Full Employment and Potential GDP

1. At full employment, the real wage rate adjusts to make the quantity of labor demanded equal the quantity of labor supplied. Potential GDP depends on the full-employment quantity of labor.

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2. Figure 15.6 illustrates how the full-employment quantity of labor determines the level of potential GDP and how an income tax changes the full-employment equilibrium.

C. The Effects of the Income Tax

1. By reducing the take-home wage of workers, the income tax lowers the supply of labor.

2. The gap between the before-tax and after-tax wage rates is like a wedge and is called the tax wedge.

3. The decrease in labor supply raises the real wage rate paid by firms and lowers the full-employment quantity of labor.

4. The decrease in the full-employment quantity of labor decreases potential GDP and aggregate supply.

D. Taxes on Expenditure and the Tax Wedge

1. Taxes on consumption expenditure add to the wedge by raising the prices paid for consumption goods and services, which is equivalent to a cut in the real wage rate.

E. Some Real World Tax Wedges

1. Figure 15.7 displays estimated tax wedges in three industrial countries.

F. Does the Tax Wedge Matter?

1. According to Edward Prescott, an economist at the University of Minnesota, the entire difference in potential GDP between France and the United States can be attributed to the difference in the tax wedge in the two countries, while about a third of the difference in potential GDP between the United Kingdom and the United States arises from the difference in the tax wedge un the two countries.

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G. Tax Revenues and the Laffer Curve

1. The relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve.

2. Figure 15.8 illustrates the Laffer curve. As the tax rate increases, tax revenues initially increase. But above a certain level, an increase in the tax rate causes tax revenues to fall.

H. The Supply-Side Debate

1. In the Reagan administration, supply-siders believed the U.S. economy was on the right-hand portion of the Laffer curve and predicted that tax revenues would increase when tax rates were cut. In reality, tax revenues fell and the deficit increased when the Reagan administration cut tax rates.

2. However, most economists recognize that tax rates have some impact on labor supply and potential GDP.

III. The Supply Side: Investment, Saving, and Economic Growth

A. The Sources of Investment Finance

1. Investment is equal to the sum of private saving and government saving, where private saving is made up of private domestic saving and foreign borrowing and government saving is equal to net taxes minus government purchases.

a) In terms of a formula, I = S + T − G + (M − X) where I is investment, S is saving, T is taxes, G is government purchases, M is imports, and X is exports.

b) Saving and foreign borrowing are the private sources of saving, so PS = S + (M − X) where PS is private saving.

c) Using the definition of private saving, I = PS + (T − G).

2. Figure 15.9 shows the sources of investment finance in the United States from 1973 through 2003.

B. Taxes and the Incentive to Save

1. A tax on interest income weakens the incentive to save and drives a wedge between the after-tax interest rate earned by savers and the interest rate paid by firms.

2. Because of the lower after-tax interest rate earned by savers, saving supply decreases. The real interest rate rises and investment decreases. The decrease in investment slows the

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growth rate of real GDP and creates a Lucas wedge between potential GDP and potential GDP that might have been.

3. Figure 15.10 illustrates how the tax on capital income decreases investment. In it, the decrease in saving supply raises the real interest rate and decreases investment.

C. Government Saving

1. Government saving is positive when the budget is in surplus, negative when the budget is in deficit, and zero when the budget is balanced.

2. The tendency for a government budget deficit to decrease investment is called a crowding-out effect.

3. Figure 15.11 illustrates the crowding-out effect. By decreasing saving supply, a budget deficit raises the real interest rate, which decreases investment.

4. The possibility that a budget deficit increases private saving supply in order to offset the decrease in saving supply is called the Ricardo-Barro effect. In this case, the saving supply curve does not shift and so there is no effect on the real interest or investment.

IV. Generational Effects of Fiscal Policy

A. Generational accounting is an accounting system that measures the lifetime tax burden and benefits of each generation.

B. Generational Accounting and Present Value

1. A present value is an amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account.

2. Because there is uncertainty about the proper interest rate to use when calculating present values, plausible alternative numbers are used to estimate a range of present values.

C. The Social Security Time Bomb

1. Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. In 2003, the fiscal balance was estimated to be $45 trillion.

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2. There are four alternatives available to address the fiscal imbalance:

a) Raise income taxes.

b) Raise social security taxes.

c) Cut social security benefits.

d) Cut federal government discretionary spending.

D. Generational Imbalance

1. Generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the current levels of taxes and benefits.

2. Figure 15.12 shows an estimate of how today’s fiscal imbalance is distributed across the current and future generations.

a) It is estimated that the current generation will pay 43 percent of the fiscal imbalance and future generations will pay 57 percent.

b) The major source of generational imbalance is Medicare.

E. International Debt

1. A large amount of U.S. investment and government expenditures have been financed by borrowing from the rest of the world.

2. Table 31.2 shows that at the end of June 2003, the United States had a net debt to the rest of the world of $4 trillion, $2.1 trillion of which is U.S. government securities.

V. Stabilizing the Business Cycle

A. Discretionary fiscal policy is a policy action that is initiated by an act of Congress. Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.

B. The Government Purchases Multiplier

1. The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand.

2. A multiplier exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.

3. The increase in security expenditures by the federal government following the terrorist attacks of September 11, 2001 generated a multiplier effect as better off security workers increased their consumption expenditures.

C. The Tax Multiplier

1. The tax multiplier is the magnification effect a change in taxes on aggregate demand.

2. A decrease in taxes increases disposable income, which increases consumption expenditure and increases aggregate expenditure and real GDP.

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3. The amount by which a tax increase lowers consumption expenditure is determined by the marginal propensity to consume. For example, if the marginal propensity to consume is 0.75, a $1 tax cut increases consumption expenditure by only 75 cents. In this case, the tax multiplier is 0.75 times the magnitude of the government purchases multiplier.

4. Congress enacted the Bush tax cut package that lowered taxes starting in 2002. These tax cuts had a multiplier effect as higher disposable income led to higher consumption expenditure.

D. The Balanced Budget Multiplier

1. The balanced budget multiplier is the magnification effect on aggregate demand of a simultaneous change in government purchases and taxes that leaves the budget balance unchanged.

2. The balanced budget multiplier is positive because a $1 increase in government purchases increases aggregate demand by more than a $1 increase in taxes decreases aggregate demand.

E. Discretionary Fiscal Stabilization

1. If real GDP is below potential GDP, the government might increase its purchases of goods and services, cut taxes, or do some of both to increase aggregate demand.

a) These policies are expansionary policies that can be used to eliminate a recessionary gap.

b) Figure 15.13 shows the effect of an expansionary fiscal policy.

2. If real GDP is above potential GDP, the government might decrease its purchases of goods and services, raise taxes, or do some of both to decrease aggregate demand.

a) These policies are contractionary policies that can be used to eliminate an inflationary recessionary gap.

b) Figure 15.14 shows the effect of a contractionary fiscal policy.

F. Limitations of Discretionary Fiscal Policy

1. In practice, fiscal policy is hampered by time lags:

a) There is a recognition lag because of the time it takes to figure out that fiscal policy actions are needed.

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b) There is a law-making lag because of the time it takes Congress to pass the laws needed to change taxes or spending.

c) There is a impact lag because of the time it takes for a change in the law to impact real GDP.

G. Automatic Stabilizers

1. Automatic stabilizers are mechanisms that stabilize real GDP without explicit action by the government. Tax revenues and expenditures that fluctuate with real GDP are automatic stabilizers.

2. Taxes that vary with real GDP are called induced taxes.

3. Government expenditure on programs that pay benefits to people and businesses depending on their economic status is called needs-tested spending.

4. Because induced taxes and needs-tested spending change with the business cycle, the government’s budget deficit also varies with this cycle. In a recession, taxes fall, spending rises, and the deficit grows; in an expansion, taxes rise, spending falls, and the deficit shrinks.

5. Figure 15.15 shows the budget deficit over the business cycle for 1983–2003.

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6. The structural surplus or deficit is the surplus or deficit that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit; that is, it is the surplus or deficit that occurs purely because real GDP does not equal potential GDP. Figure 15.16 illustrates these ideas.

R e a d i n g B e t w e e n t h e L i n e s The news article discusses the large increase in federal spending under the Bush administration. The analysis compares the Bush and Clinton budgets by category. Transfer payments increased substantially between 2000 and 2004, while personal income taxes decreased dramatically over the same period.

N e w i n t h e S e v e n t h E d i t i o n The chapter is revised considerably from the sixth edition. Data are updated for the 2004 budget. The material on supply-side effects of fiscal policy is completely revised and extended to two sections. There is a new section on the generational effects of fiscal policy. The material on stabilization policy and policy multipliers is simplified. The Reading Between the Lines analyzes the large increase in government expenditures under the Bush administration.

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Te a c h i n g S u g g e s t i o n s 1. The Federal Budget Deficit and debt. Many students need help with the distinction between the deficit and the debt (and

with what happens to the debt when there is a surplus). Use the student loan or credit card analogy. Explain that the budget balance—the deficit or surplus—is just like a personal budget balance—the amount that a student borrows or pays back during a given year. The debt—the amount owed by the government—is like the balance on a student loan or credit card account. Students (usually) have a budget deficit and increasing debt. And graduates with a job (usually) have a budget surplus and decreasing debt.

An interesting historical episode. During the mid-1830s—a long time ago—the U.S. government had virtually repaid all its debt. At that time the government faced a problem that doesn’t occur today: it had a surplus and didn’t know what to do with it. The decision was made to transfer money to the state governments. Each state was to receive $400,000 in four payments of $100,000 each. The first three payments were made, but the last one was postponed because of a recession in 1837 that lowered the federal government’s revenue and then was never made. In the 1970s, faced with a severe budget crunch, the State of New York sued to receive that last payment plus interest. The state lost the suit and so the last payment probably will never be made! (You might remark that $100,000 invested in 1837 at the average interest rate would have accumulated to about $23 billion by 2002!)

Does the debt matter? You can have endless fun debating this question. If you do engage your students in this question, you will want to point them to thinking about: 1. The distinction between domestically held debt and foreign held debt.

2. No matter how much the government owes (or has invested in trust funds such as those for Social Security and Medicaid), every single year, Y = C + I + G + X – M, so the resources available depend on productive capacity, not on paper claims.

2. The Supply Side: Employment and Potential GDP The Laffer curve. Discuss how past changes in tax rates have provided some empirical evidence on

the location of the United States on the Laffer curve. In the Reagan administration, a cut in tax rates was followed by higher budget deficits. In the Clinton administration, a rise in tax rates was followed by higher tax revenues and eventually budget surpluses. In the Bush administration, a cut in tax rates was followed by higher budget deficits. Evidently, the United States is on the lefthand slope of the Laffer curve. But are other countries on the righthand slope? It is likely that, prior to Margaret Thatcher, the United Kingdom was. Beyond tax revenues, there is an interesting correlation between U.K. tax rates and the migration of famous actors and popular musicians. When marginal tax rates were extremely high in the 1960s, members of bands such as the Rolling Stones moved from London to New York. In recent years, with lower marginal tax rates, high earning celebrities have moved to London. Apparently, despite any political pronouncements to the contrary, many celebrities show a revealed preference for being supply-siders.

3. The Supply Side: Investment, Saving, and Economic Growth Crowding out. The text introduces the crowding out effect in Chapter 24 and doesn’t discuss it again

until this chapter. You can easily reinforce the idea using national income accounting and the idea of full employment. If Y = potential GDP, an increase in G must crowd out something because Y = C + I + G + X – M. C and M depend (primarily) on Y, so they don’t change (much). Exports depend primarily on the buying plans of foreigners. That leaves I as the main item that gets crowded out by an increase in G at full employment.

4. Generational Effects of Fiscal Policy Fiscal imbalance. The $45 trillion estimate of the fiscal imbalance should be an eye-opener for

students, especially since many of them fall in the “future generations” category for generational

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accounting purposes. Recently, however, the economist Michael Boskin of Stanford University has argued that the $45 trillion fiscal imbalance is somewhat overstated. In particular, he estimates an extra $12 trillion in tax revenues (in present value terms) that will result from baby-boomers paying taxes on their currently tax-deferred retirement savings when they retire.

5. Stabilizing the Business Cycle Been here before. Point out that the autonomous expenditure multiplier and the government

purchases multiplier are identical. And although the tax multiplier is different, it builds on the same principle –a change in autonomous expenditure that gets multiplied by that same multiplier. But a dollar of tax hike (or cut) doesn’t translate to a dollar change in autonomous expenditure. The dollar gets multiplied by the MPC, so autonomous expenditure changes by less than a dollar (and in the opposite direction to the tax change).

Circular flow version. Some instructors like to illustrate the difference between the spending multipliers and the tax multiplier using the circular flow diagram and to emphasize that the change in the circular flow occurs at different points. For the change in government purchases (or investment), AE and AD change directly, whereas for a change in taxes, disposable income changes, which brings a smaller change in consumption expenditure in the first round than the change in taxes.

Balanced budget multiplier. Although the text doesn’t discuss the exact size of the balanced budget multiplier, it is a small step and is easily covered if you wish to do so. Formally, just add the government purchases multiplier and the tax multiplier together 1/(1 – MPC) – MPC/(1 – MPC) = (1 – MPC)/(1 – MPC) = 1. Intuitively, the net increase in autonomous expenditure is (1 – MPC) times the size of the balanced budget change in G and T. And it gets multiplied by 1/(1 – MPC).

Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government purchases shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the differences between the potential of fiscal policy under a parliamentary system and under the U.S. system; the length of time it took the congress to pass the 2002 ‘stimulus’ package, compared to almost immediate executive-initiated changes to fiscal policy in Canada and Western Europe, make the point that discretionary fiscal policy is feasible under some governmental systems but only in extreme circumstances in the United States.

Been here before again! The discussion of the impact of induced taxes and imports on the size of the multiplier also repeats material in Chapter 13, but is worth emphasizing again because students often do not fully absorb this at first.

Automatic stabilizers. Automatic stabilizers are worth substantial emphasis. Point out that stabilization doesn’t mean stability! (A ship sways in the waves but by less than it would without its automatic stabilizers.) A little history can help students appreciate the importance of automatic stabilizers. Refer back to the figure of the business cycle throughout the twentieth century in Figure 6.1, and the data on the length and magnitude of cycles before and after World War II, in Table 6.1. Then ask students what percentage of income earners paid income tax and Social Security contributions and were covered by unemployment insurance in 1940 compared to after World War II. The inference that it is the structural changes that made automatic stabilizers far more prominent in the U.S. economy will seem clear.

Cyclical and structural budget balances. Cyclical and structural budget balances are a difficult concept for many students, but important because of the appropriate measure of fiscal stance. An effective way to help students see that tax revenues and expenditures will vary as depicted in Figure 15.16 is to remind them that potential GDP corresponds to full employment, and employment (and

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thus the number of tax payers and recipients of unemployment compensation) changes when GDP varies.

T h e B i g P i c t u r e

Where we have been

This chapter builds directly on Chapter 13 concerning the equilibrium level of expenditure and the aggregate demand curve. Chapter 15 also revisits the material on the labor market and saving and investment from Chapter 8.

Where we are going

Chapter 16 on monetary policy completes the material on macroeconomic stabilization policies.

O v e r h e a d Tr a n s p a r e n c i e s

Transparency Text figure Transparency title

96 Figure 15.6 The Effects of the Income Tax on Aggregate Supply

97 Figure 15.10 The Effects of a Tax on Capital Income

98 Figure 15.13 Expansionary Fiscal Policy

99 Figure 15.14 Contractionary Fiscal Policy

E l e c t r o n i c S u p p l e m e n t s MyEconLab

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Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are automatically graded and results are tracked using an online grade book.

PowerPoint Lecture Notes

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PowerPoint Electronic Lecture Notes for students are available in MyEconLab.

Instructor CD-ROM with Computerized Test Banks

This CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software.

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A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s 11. What is the distinction between the government’s budget deficit and the government’s debt? 12. Suppose that you wanted to decrease the government’s debt. What would you need to do? Would

you favor a reduction in expenditure or an increase? A decrease in taxes or an increase? Some combination of the two? Why? Specifically, what actions do you suggest?

13. Suppose that the government increases transfer payments by $10 billion and pays for the increase by raising taxes by $10 billion. What is the total effect of these two changes?

14. Explain why higher marginal tax rates reduce the size of the government spending multiplier. 15. In the AD/AS model, an increase in government spending causes a (short-run) increase in

equilibrium real GDP. How does the increase in equilibrium GDP compare with the increase in GDP shown in the aggregate expenditure/45°−line model? If the amount is the same, why? If it differs, why?

16. Suppose that investment decreases. Without any action on the part of the government, what happens to real GDP and unemployment? What might the government do to offset these effects?

17. Why are fiscal policy multipliers smaller in the long run than in the short run? 18. Suppose that exports (autonomously) increase. What happens to the aggregate expenditure curve?

The equilibrium level of aggregate expenditure? The aggregate demand curve? 19. Which do you think is a better measure of the stance of fiscal policy: the actual budget deficit or

surplus or the cyclical deficit or surplus? In other words, which better indicates whether fiscal policy is expansionary or contractionary? Why?

10. Why does a change in income taxes have a different effect on aggregate supply than a change in government expenditures?

11. Suppose government increases taxes and defense purchases by equal dollar amounts. Will there be any short-run effect on equilibrium GDP? Why? Will the size of the short-run effect depend on who pays the taxes? Why? How about the long run?

12. Suppose because of a recession, most state governments experience reductions in tax revenues, and respond by reducing their expenditures and increasing their taxes to keep their state budgets in balance (a constitutional requirement in many U.S. states). Will this have any effect on the recession, and if so, what?

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A n s w e r s t o t h e R e v i e w Q u i z z e s

Page 367 (page 739 in Economics) 1. Fiscal policy is changes in the federal budget, that is, government expenditures and taxes, that are

designed to affect the state of economic activity. Fiscal policy is created by Congress and the president. It is a key tool that may be used to influence employment and economic activity. Fiscal policy also impacts other economic variables, such as the price level and distribution of income.

2. Each year the president proposes the budget that Congress amends and enacts.

3. Each year the Budget Committees of the House of Representatives and the Senate consider the budget proposed by the president, and develop their own ideas of how it should be modified. Eventually, formal conferences between the two houses resolve the differences between them and a series of spending acts and an overall budget act passed.

4. Take the budget for 2004 as an example in answering this question. In February 2003 the president proposed a budget to Congress. Then, from February until October 1, 2003, the Congress debated the budget, amended it, and eventually passed the necessary budget bills. The president then signed or vetoed the different budget bills that were presented to him. When the president vetoes bills, the Congress may over-ride the veto or pass other bills, acceptable to the president. Fiscal year 2004 begins on October 1, 2003 and runs until September 30, 2004. During this year the Congress may pass—and the president may sign—supplementary bills. Then, after the fiscal year ends, accounts are prepared and the “official” amounts of expenditures, tax revenues, and budget deficit or surplus are reported.

5. Currently, the U.S. federal government is running a budget deficit.

Page 370 (page 742 in Economics) 1. A tax on labor income drives a wedge between the take-home wage of workers and the wage paid

by firms. This wedge leads to a decrease in the supply of labor. That is, for each before-tax wage rate, workers provide a lower quantity of labor when faced with a tax that lowers their after-tax wage. The decrease in labor supply means that the real wage rate paid by firms rises, even though the after-tax wage received by workers falls. The decrease in labor supply also means that the quantity of employment at full employment (i.e., equilibrium in the labor market) falls.

2. By decreasing employment, the tax wedge lowers potential GDP.

3. The reason is that a tax on consumption raises the prices paid for consumption goods and services and is equivalent to a cut in the real wage rate from the perspective of workers.

4. The Laffer curve is the relationship between the tax rate and the amount of tax collect. The amount of tax collected is hypothesized to increase with the tax rate only up to a certain tax rate, after which, further increases in the tax rate actually cause tax revenues to fall. When tax rates are higher than the tax rate that maximizes tax revenues, a country is said to be on the wrong side of the Laffer curve. It is unlikely that the United States is on the wrong side of the Laffer curve because U.S. tax rates are among the lowest in the industrial world and past changes in tax rates have produced changes in tax revenues of the same direction.

Page 374 (page 746 in Economics) 1. A tax on labor income lowers the level of potential GDP, while a tax on interest income lowers

saving and investment and, therefore, lowers the growth rate of real GDP. That is, it creates a Lucas wedge, which is an ever widening gap between potential GDP and the potential GDP that might have been, instead of the constant gap created by the tax on labor income.

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2. Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans. In particular, by driving a wedge between the real interest rate savers receive and firms pay, the tax on interest income decreases saving supply, which lowers investment and saving in the economy.

3. Yes, a government budget deficit crowds out investment. Because a budget deficit represents negative government saving, it decreases saving supply. The decrease in saving supply raises the real interest rate and lowers investment.

4. The Ricardo-Barro effect is the idea that private saving supply increases in the face of a budget deficit as taxpayers anticipate higher taxes in the future when the government must pay the principle and interest on the bonds it used to finance the deficit. There are many reasons why the Ricardo-Barro effect might not operate fully. One is that some taxpayers may not want to neutralize the effects of the government deficit on their consumption plans, but instead they adjust their consumption by a fraction of the change in their disposable income, as suggested by the consumption function presented in Chapter 13.

Page 376 (page 748 in Economics) 1. A present value is the amount of money that, if invested today, will grow to equal a given future

amount when the interest that it earns is taken into account. Suppose you win a $20 million jackpot in the lottery and are told that you will receive monthly payments of $33,333 for the next 50 years or you can opt for an upfront lump-sum payment of a smaller amount. The smaller upfront payment is a present value. If it is high enough, you might well take it even though it is less than $20 million. Why? One reason, of course, is that you might die before the 50 years are up. But that is just an extreme version of why you would prefer the cash now rather than 50 years from now. In general, you would discount the future because having the cash now gives you more options, including spending it before you die or using it to buy an interest-bearing asset. Given the interest rate, the amount you would accept as an upfront cash payment is the present value of the $20 million jackpot.

2. Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. Generational imbalance is the division of the fiscal imbalance between the current and future generations assuming that the current generation continues to enjoy the current levels of taxes and benefits. If benefits exceed taxes, there is a fiscal imbalance. Generational imbalance has to do with who will have to make up the fiscal imbalance. Social security taxes on the current generation more than pay for the social security benefits. But taxes to be paid by the current generation will only fund about 50 percent of the benefits that they will receive. Without a change in taxes or benefits, the rest of cost of the medicare benefits for the current generation will fall on future generations.

3. In 2003, the fiscal imbalance was estimated to be $45 trillion. The generational imbalance estimates suggest that the current generation will pay an 43 percent and future generations will pay 57 percent of the fiscal imbalance.

4. The source of the fiscal imbalance is largely the social security and medicare obligations made under current law. The painful choices are to raise income taxes, raise social security taxes, cut social security benefits, or cut federal government discretionary spending.

5. The U.S. government’s future obligation to the rest of the world is to pay back the $2.1 trillion in U.S. government securities currently held outside the United States.

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Page 381 (page 753 in Economics) 1. In an inflationary gap, the government can decrease purchases or raise taxes in order to lower

aggregate demand and push the economy back to potential GDP. In a recessionary gap, the government can increase purchases or lower taxes in order to increase aggregate demand and push the economy back to potential GDP.

2. The magnitude of the multiplier effect from a change in government purchases is larger than the magnitude of the multiplier effect from a change in taxes because a dollar change in government purchases initially changes aggregate expenditure by a dollar, while a dollar change in taxes initially changes disposable income, and thus changes aggregate expenditure by less than a dollar because some of the change in lump-sum taxes affects saving and not consumption expenditure.

3. While a balanced budget increase in spending does not change disposable income and, therefore, consumption component of aggregate expenditure, it does increase the government purchases component of aggregate expenditure.

4. Income taxes and needs-tested programs both work as automatic stabilizers because they decrease the effect a change in income has on aggregate expenditure. For instance, when income decreases, consumption expenditure and hence aggregate expenditure decrease. But, with the fall in income, income taxes decrease and entitlement spending increases so that disposable income does not fall as much as does income. Thus the fall in consumption expenditure is lessened, so that the fall in aggregate expenditure is likewise lessened.

5. A budget deficit needs government action to decrease it when the deficit is a structural deficit. If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain. However, if the deficit is a cyclical deficit, then when the economy returns to full employment, the deficit will disappear.

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A n s w e r s t o t h e P r o b l e m s 1. a. The supply of labor will decrease. The supply of labor curve will shift leftward. The supply of

labor decreases because at each real wage rate, the after-tax wage rate received by workers will be lower given an increase in the tax rate on labor income.

b. The demand for labor will remain the same. The demand for labor depends on the productivity of labor, which remains the same following the increase in the tax rate on labor income.

c. The equilibrium level of employment will decrease. With the rightward shift in the supply of labor curve, the real wage rate rises, and the quantity of labor demanded decreases along the demand for labor curve. Equilibrium employment decreases.

d. The equilibrium pre-tax wage rate will increase. The leftward shift of the supply of labor curve leads to movement up along the demand for labor curve.

e. The equilibrium after-tax wage rate will decrease. The increase in the tax rate on labor income increases the wedge between the pre-tax wage rate and the after-tax wage rate. The pre-tax wage rate increases but not by as much as the increase in tax. So the after-tax wage rate will decrease.

f. Potential GDP will decrease. The equilibrium level of employment is the full employment. So as full employment decreases, potential GDP decreases along the production function.

g. The cross-country evidence for the United States, the United Kingdom, and France on marginal income tax rates and employment suggests that tax rates on labor income have a significant effect on the labor market.

2. a. The supply of labor will increase. The supply of labor curve will shift rightward. The supply of labor increases because at each real wage rate, the after-tax wage rate received by workers will be higher given a decrease in the tax rate on labor income.

b. The demand for labor will remain the same. The demand for labor depends on the productivity of labor, which remains the same following the decrease in the tax rate on labor income.

c. The equilibrium level of employment will increase. With the rightward shift in the supply of labor curve, the real wage rate decreases and the quantity of labor demanded increases along the demand for labor curve. Equilibrium employment increases.

d. The equilibrium pre-tax wage rate will decrease. The rightward shift of the supply of labor curve leads to movement down along the demand for labor curve.

e. The equilibrium after-tax wage rate will increase. The decrease in the tax rate on labor income decreases the wedge between the pre-tax wage rate and the after-tax wage rate. The pre-tax wage rate decreases but not by as much as the decrease in tax. So the after-tax wage rate will increase.

f. Potential GDP will increase. The equilibrium level of employment is the full employment. So as full employment increases, potential GDP increases along the production function.

g. If the cut in the labor income tax rate were offset by an increase in the sales tax, it would be equivalent to no change in the real wage rate received by workers. So the supply of labor would not change. With no change in the supply of labor or the demand for labor, equilibrium employment would remain the same and equilibrium before-tax and after-tax wages would remain the same. Potential GDP would remain unchanged.

h. The cross-country evidence for the United States, the United Kingdom, and France on marginal income tax rates and employment suggests that higher tax on labor income has a significant effect on the labor market.

3. a. Tax revenue is equal to $1,200 billion. From the circular flow, we know that I = S + T – G + M – X.

Re-arranging the equation gives T = I – S + G – M + X, which equals $1,200 billion.

b. The government budget balance is T – G, which equals $1,200 billion – $1,500 billion, which equals –$300 billion or, equivalently, the government budget deficit is $300 billion.

3 5 2 C H A P T E R 1 5

c. It is exerting a negative influence on investment by decreasing saving supply, which drives up the real interest rate and crowds out investment.

d. A decrease in the budget deficit by increasing taxes or decreasing government purchases would increase saving supply, which would lower the real interest rate and increase investment. The increase in investment would increase economic growth.

4. a. Government purchases equal $400 billion. From the circular flow, we know that I = S + T – G + M – X.

Re-arranging the equation gives G = S – I + T + M – X, which equals $1,200 billion.

b. The government budget balance is T – G, which equals $100 billion or, equivalently, the government budget surplus is $100 billion.

c. It is exerting a positive influence on investment by increasing saving supply, which decreases the real interest rate and stimulates investment.

d. A further increase in taxes or decrease government purchases would increase saving supply, which would lower the real interest rate and increase investment. The increase in investment would increase economic growth.

5. a. The increase in government expenditures by $100 billion decreases saving supply, which drives up the real interest rate and crowds out investment.

b. The stronger the Ricardo-Barro effect, the less the decrease in saving supply as taxpayers increase saving to be able to pay the higher future taxes that will be needed to pay back the principle and interest on the bonds used to finance the current government expenditures.

6. a. The decrease in government expenditures by $100 billion increases saving supply, which decreases the real interest rate and stimulates investment.

b. The stronger the Ricardo-Barro effect, the less the increase in saving supply as taxpayers expect future taxes to be lower due to the decline in government expenditures.

7. a. Given a positive rate of inflation, the true tax rate on capital income would fall because the part of the capital income that is received in compensation for inflation is no longer taxed.

b. With a lower tax rate on capital income, saving supply would increase as the after-tax real rate of return would increase.

c. Investment demand would remain the same because it depends on how productive capital is and the productivity of capital does not necessarily change when the tax code changes.

d. The increase in saving supply, represented by a rightward shift in the saving supply curve, leads to a lower equilibrium real interest rate and a higher equilibrium amount of investment.

8. a. The increase in the inflation rate would increase the true tax rate on capital income because the part of the capital income that is received in compensation for inflation is larger and the tax paid on capital income will increase.

b. With a higher tax rate on capital income, saving supply would decrease as the after-tax real rate of return would decrease.

c. Investment demand would remain the same because it depends on how productive capital is and the productivity of capital does not necessarily change when the inflation rate changes.

d. The decrease in saving supply, represented by a leftward shift in the saving supply curve, leads to a higher equilibrium real interest rate and a lower equilibrium amount of investment.

9. a. Fiscal policy that increases spending or decreases taxes would boost aggregate demand. In terms of automatic fiscal policy, needs-tested spending increases in recessions and induced taxes fall. Congress may also use discretionary policy by passing a new spending bill or a cut in tax rates.

b. An increase in government purchases with an offsetting increase in taxes would not bring a budget deficit but would increase aggregate demand due to the direct increase in the government purchases component of aggregate expenditure.

F I S C A L P O L I C Y 3 5 3

c. The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP.

10. a. Fiscal policy that decreases spending or increases taxes would decrease aggregate demand. In terms of automatic fiscal policy, need-tested spending decreases in expansions and induced taxes increase. Congress may also use discretionary policy by cutting spending programs or increasing tax rates.

b. A decrease in government purchases with an offsetting decrease in taxes would not bring a change in government saving and so would not change investment and the growth of real GDP. However, the increase in taxes would lead to a decrease in the level of potential GDP.

c. The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP.

11. a. We know that at least some of the budget deficit in a recession reflects a cyclical deficit as needs-tested spending is higher and induced taxes are lower than at potential GDP. However, some of the budget deficit might be a structural deficit. The structural deficit is the deficit that would exit if real GDP equaled potential GDP and the economy were at full employment.

b. We know that automatic stabilizers are increasing aggregate demand relative to what it would be otherwise in a recession. That is, aggregate demand decreases in a recession, but it would decrease by more without the increase in needs-tested spending and the decrease in induced taxes that produce the cyclical deficit.

c. A discretionary increase in government purchases, if not reversed following the end of the recession, will generate a structural deficit unless there was already a larger structural surplus, in which case the increase in government purchases would lower the structural surplus.

12. a. The economy is at an above full-employment equilibrium. Real GDP exceeds potential GDP. There is a budget deficit, but with potential GDP less than real GDP, the economy has larger structural deficit than budget deficit. The budget deficit is a cyclical surplus because the actual deficit minus the structural deficit is positive. So the budget deficit is composed of a structural deficit and a cyclical surplus.

b. We know that automatic stabilizers are decreasing aggregate demand relative to what it would be otherwise in an inflationary gap. That is, aggregate demand increases in boom, but it would increase by more without the decrease in need-tested spending and the increase in induced taxes that produce the cyclical surplus.

c. A discretionary decrease in government purchases would decrease the structural deficit. Following the change in fiscal policy, government expenditure would be closer to tax revenues even when the economy returned to full employment.