federal government expenditures: purchases. interest on the national debt. grants to state and local...

Federal government expenditures:•Purchases.•Interest on the national debt. •Grants to state and local governments. •Transfer payments.

An Overview of Government Spending

and Taxes

The Federal Government’s Share of Total Government Expenditures, 1929–2010

Federal Purchases and Federal Expenditures as a Percentage of GDP,

1950–2010

Federal Government Expenditures, 2010

Federal Government Revenue, 2010

AD1

• Equilibrium below full employment. Two options

PriceLevel

LRAS

YFY1

P2

AD2

Goods & Services(real GDP)

directs theEconomy to full-employment

SRAS1

P1

1. Wait for SRAS1 to shift out to SRAS2

SRAS2

P3

market self-adjustment may be a lengthyprocess.

e1

E2

2. Shift AD1 out to AD2

E3

AD1

• Equilibrium above full employment at Y1.

PriceLevel

LRAS

YF Y1

P3

AD2 Goods & Services(real GDP)

restrains demand and helps control inflation.

SRAS2

P1

1. Will lead to the long-run equilibrium E3 at a higher price level as SRAS shifts to SRAS2. or

SRAS1

P2

E3

2. Reduce demand to AD2 and lead to equilibrium E2.

e1

E2

12 of 75© 2013 Pearson Education, Inc. Publishing as Prentice Hall

A Summary of How Fiscal Policy Affects Aggregate Demand

Countercyclical Fiscal Policy

ProblemType of Policy

Actions by Congress and the President Result

Recession Expansionary Increase government spending or cut taxes

Real GDP and the price level rise.

Rising inflation

Contractionary

Decrease government spending or raise taxes

Real GDP and the price level fall.

The initial increase in government purchases is autonomous

it is a result of a decision by the government and is not directly caused by changes in the level of real GDP.

The increases in consumption spending that result from the initial autonomous increase in government purchases are induced

because they are caused by the initial increase in autonomous spending.

The Multiplier Effect and Aggregate Demand

Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

The Multiplier Effect of an Increase in Government Purchases

The new spending and increased real GDP in each period is shown in green, and the level of spending from the previous period is shown in orange. The sum of the orange and green areas represents the cumulative increase in spending and real GDP. In total, equilibrium real GDP will increase by $200 billion as a result of an initial increase of $100 billion in government purchases.


The ratio of the change in equilibrium real GDP to the initial change in government purchases:

purchases governmentin Change

GDP real mequilibriuin Changemultiplier purchases Government


Tax cuts also have a multiplier effect.

in taxes Change

GDP real mequilibriuin ChangemultiplierTax

The tax multiplier is negative because changes in taxes and changes in real GDP move in opposite directions:

An increase in taxes reduces disposable income, consumption, and real GDP,and a decrease in taxes raises these.

We would expect the tax multiplier to be smaller in absolute value than the government purchases multiplier.


The Multiplier Effect and Aggregate Supply

The economy is initially at point A. An increase in government purchases causes the aggregate demand curve to shift to the right, from AD1 to the dashed AD curve. The multiplier effect results in the aggregate demand curve shifting further to the right, to AD2 (point B). Because of the upward-sloping supply curve, the shift in aggregate demand results in a higher price level. In the new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level.


The Effect of Changes in Tax Rates

A change in tax rates has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount.The higher the tax rate, the smaller the multiplier effect.

A cut in tax rates affects equilibrium real GDP through two channels:1.A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending (and saving).2.A cut in tax rates increases the size of the multiplier effect.


The Multipliers Work in Both Directions

Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP.

Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case, the effect is negative.

AD0

1. Equilibrium at E0

PriceLevel

LRAS

Y0Y1

AD1 Goods & Services(real GDP)

P0

SRAS1

P1

E0

e1

2. AD decreases to AD1 and output falls to Y1

AD0

3. While policy is being enacted, private investment has begun to recover.

PriceLevel

LRAS

Y0Y1


P0

SRAS1

P1

AD2

E0

e1

4. AD has begun shifting back to AD0 on its own, the effects of fiscal policy over-shift AD to AD2.

AD1

AD1

AD0

• The price level in the economy rises (from P1 to P2) as the economy is now overheating.

PriceLevel

LRAS

Y0Y1

P2


P0

SRAS1

P1

AD2

E0

e1

e2

Y2

• Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS2 (driving the price level up to P3).

P3

SRAS2

E3

AD0

1. Demand shifts AD out to AD2, and prices upward to P2.

PriceLevel

LRAS

Y0

P2


P0

SRAS1

E0

Y2

2. Restrictive Fiscal Policy is considered

AD2

e2

AD1

AD0

2. The price level falls (from P2 to P1) as the economy is thrown into a recession.

PriceLevel

LRAS

Y0Y1

P2


P0

SRAS1

P1

AD2

E0

e1

e2

Y2

3. With the timing lag, fiscal policy does not work instantaneously.

4. Investment returns to its normal rate (shifting AD2 back to AD0).

PriceLevel

LRAS

Y0


P0

SRAS1

AD2

5. The effects of fiscal policy over-shift AD to AD1.

P2 e2

Y2

AD1

Suppose that shifts in ADare difficult to forecast.

E0

AD0

Increase in budget deficit

Higher realinterest rates

Inflow of financial capital from abroad

Decline inprivate investment

Appreciation of the dollar

Decline in net exports

Did the Stimulus Package of 2009 Work?

1. Congress enacted a tax cut totaling $95 billion that took the form of rebates of taxes already paid that were sent to taxpayers between April and July 2008.

2. One-time tax rebates increase consumers’ current income but not their permanent income, which reflects their expected future income.

3. A tax rebate is likely to increase consumption spending less than would a permanent tax cut.

Panel (a) shows how the increases in spending were distributed,and panel (b) shows how the tax cuts were distributed.

American Recovery and Reinvestment Act of 2009

YearChange in Real

GDPChange in the

Unemployment Rate

Change in Employment

(millions of people)

2009 0.9% to 1.9% −0.3% to −0.5% 0.5 to 0.9

2010 1.5% to 4.2% −0.7% to −1.8% 1.3 to 3.3

2011 0.8% to 2.3% −0.5% to −1.4% 0.9 to 2.7

2012 0.3% to 0.8% −0.2% to −0.6% 0.4 to 1.1

CBO Estimates of the Effects of the Stimulus Package

Why Was the Recession of 2007–2009 So Severe?

The recession of 2007-2009 was accompanied by a significant financial crisis, which the U.S. economy had not experienced since the Great Depression of the 1930s.


Economic Variable Average Change

Average Duration of Change

Number of Countries

Unemployment rate

+7 % 4.8 years 14

Real GDP per capita

−9.3% 1.9 years 14

Real stock prices −55.9% 3.4 years 22

Real house prices −35.5% 6 years 21

Real government debt

+86% 3 years 13

The table shows the average change in key economic variables during the period following a financial crisis for a number of countries, including the United States during the Great Depression and European and Asian countries in the post–World War II era.

DurationDecline in Real GDP

Peak Unemployment Rate

Average for postwar recessions

10.4 months −1.7% 7.6%

Recession of 2007–2009 18 months −4.1% 10.1%

The recession lasted nearly twice as long as the average of earlier postwar recessions, GDP declined by more than twice the average, and the peak unemployment rate was about one-third higher than the average.

Because most people did not see the financial crisis coming, they also failed to anticipate the severity of the 2007–2009 recession.


Expenditures < Revenues

Expenditures > Revenue

Discretionary changes in taxes and/or spending affect the Budget

Most of the increase in the federal budget deficit during a typical recession takes place without Congress and the president taking any action, but is instead due to the effects of the automatic stabilizers.

Deficits occur automatically during recessions for two reasons:

1.During a recession, wages and profits fall, causing government tax revenues to fall.

2.The government automatically increases its spending on transfer payments when the economy moves into recession.

Many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP.

Attempting to balance it every year might mean taking actions that would destabilize the economy.

Some even argue that the federal government should normally run a deficit, even at potential GDP.

The large deficits incurred during World Wars I and II, the Great Depression, and the 1980s and early 1990s increased the ratio of debt to GDP. The large deficits of 2009 to 2011 caused the ratio to spike up to its highest level since 1947.

The federal government can raise the funds it needs through taxes or spending cuts.

If crowding out occurs, there will be a lower capital stock in the long run and a reduced productive capacity.

Some of the debt was incurred to finance improvements in infrastructure, or to finance research and development.

“Because fiscal policy actions primarily affect aggregate supply rather than aggregate demand, they are sometimes referred to as supply-side economics.”

Tax wedge The difference between the pretax and posttax return to an economic activity.When workers, savers, investors, or entrepreneurs change their behavior as a result of a tax change, economists say that there has been a behavioral response to the tax change.

We next look briefly at the effects on aggregate supply of cutting some common taxes.

The Long-Run Effects of Tax Policy

1. Individual income tax. Sole proprietorships’ profits and households’ returns from saving are taxed at the individual income tax rates.

So, cutting these rates not only reduces the tax wedge faced by workers, thereby increasing the quantity of labor supplied, but also raises the return to entrepreneurship, encouraging the opening of new businesses, and increases the return to saving.

People are not working because taxes are too high.

• Corporate income tax. The federal government taxes the profits earned by corporations under the corporate income tax.

Cutting the marginal corporate income tax rate would encourage investment spending by increasing the return corporations receive from new investment goods, potentially increasing the pace of technological change if innovations are embodied in these goods.

or…

Increase profits of business owners

• Taxes on dividends and capital gains. Corporations distribute some of their profits in the form of payments known as dividends to shareholders, who may benefit from higher corporate profits by receiving capital gains, which are increases in the prices of assets.

Lowering the tax rates on dividends and capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate.

If the tax code were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. Put HB Block out of business

In addition to wasting resources, the complexity of the tax code may also distort the decisions made by households and firms.

A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments.

Tax Simplification

Figure 16.16

The Supply-Side Effects of a Tax Change

The economy’s initial equilibrium is at point A. With no tax change, the long-run aggregate supply curve shifts to the right, from LRAS1

to LRAS2. Equilibrium moves to point B, with the price level falling from P1 to P2 and real GDP increasing from Y1 to Y2.With tax reductions and simplifications, the long-run aggregate supply curve shifts further to the right, to LRAS3, and equilibrium moves to point C, with the price level falling to P3

and real GDP increasing to Y3.

Most (?) economists would agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labor supplied, cutting the corporate income tax will increase investment spending, and so on.

The magnitude of the effects is the subject of considerable debate, however.

Economists who are skeptical of their magnitude believe that tax cuts have their greatest effect on aggregate demand rather than on aggregate supply.

How Large Are Supply-Side Effects?

AD1

PriceLevel

LRAS1

YF2YF1

AD2


With time, lower tax ratespromote more rapid growth (shifting LRAS and SRASout to LRAS2 and SRAS2).

SRAS1

P0

SRAS2

E1

LRAS2

E2

1. Lower marginal tax rates shifts AD1 out to AD2, and SRAS & LRAS shift to the right.

2. If the tax cuts are financed by budget deficits, AD may expand by more than supply, bringing an increase in the price level.

• Their share of taxes paid has increased as the top tax rates have declined.

• This indicates that the supply side effects are strong for these taxpayers.

Share of personal income taxes paid by top ½ % of earners

1964-65Top rate cut from91% to 70%

1981Top rate cut from70% to 50%

1986Top rate cut from50% to 30%

1990-93Top rate raised from30% to 39.6%

30 %

28 %

26 %

24 %

22 %

20 %

18 %

1960

16 %

14 %

199519901980197519701965 1985 2000

1997Capital gainstax rate cut

2001-2004Top rate cut from39.6% to 35%

2005

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