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Public Finance: Taxes and Fiscal Policy Fundamentals of Finance – Lecture 10

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Public Finance: Taxes and Fiscal Policy. Fundamentals of Finance – Lecture 10. Outline. Income Taxes Personal Corporate Consumption and Sales Taxes Taxes on Wealth and Property Fiscal Policy The Keynesian View The New Classical View Fiscal Policy C hanges and Problems of Timing - PowerPoint PPT Presentation

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Page 1: Public Finance: Taxes and Fiscal Policy

Public Finance:Taxes and Fiscal Policy

Fundamentals of Finance – Lecture 10

Page 2: Public Finance: Taxes and Fiscal Policy

Outline

1. Income Taxesa) Personalb) Corporate

2. Consumption and Sales Taxes3. Taxes on Wealth and Property4. Fiscal Policy

a) The Keynesian Viewb) The New Classical Viewc) Fiscal Policy Changes and Problems of Timingd) Supply-Side Effects of Fiscal Policy

Page 3: Public Finance: Taxes and Fiscal Policy

1. Income taxa) Personal tax

Page 4: Public Finance: Taxes and Fiscal Policy

Comprehensive Income: The Haig-Simons Definition

It is “the exercise of control over the use of society’s scarce resources.”

Algebraically it is defined as

I = C + NW Where

I = Income

C = Consumption

NW = The Change in Net Worth

Page 5: Public Finance: Taxes and Fiscal Policy

Implications of the Haig-Simons Definition

• If a person borrows to consume, there is no increase in income because the change in net worth is negative.

• If a person sells an asset so as to consume, there is no increase in income.

Page 6: Public Finance: Taxes and Fiscal Policy

Capital Gains

• Capital gains are the increased value of assets that a person holds.

• If a person owns a stock that has gone up in value, their net worth increases and therefore they have an increase in income by this definition.

• This is true whether or not they actually sell the asset and see the money in their bank accounts.

Page 7: Public Finance: Taxes and Fiscal Policy

Realized and Unrealized Capital Gains

• Realized Capital Gains are those gains that a person has received by selling an asset.

• Unrealized Capital Gains are those gains that a person has not yet received by selling an asset but exist only on paper as the market price of the asset they hold has increased.

Page 8: Public Finance: Taxes and Fiscal Policy

An Income Statement • Sources of Funds:

– Earnings from Sale of Productive Services– Transfer Payments Received – Capital Gains (or Losses)

• Uses of Funds: – Consumption – Taxes – Donations – Gifts– Saving (Increases in Net Worth)

Sources = Uses So • Earnings + Transfer Payments + Net Capital Gains =

Consumption + Taxes + Donations + Gifts + Saving

Page 9: Public Finance: Taxes and Fiscal Policy

Modifications to the Income Definition

• The cost of acquiring income needs to be accounted for in the definition.

• Earnings + Transfer Payments + Net Capital Gains – Cost of Acquiring Income

= Consumption + Taxes + Donations + Gifts + Saving – Cost of Acquiring Income

Page 10: Public Finance: Taxes and Fiscal Policy

Problems with Measuring Income using the Haig-Simons Definition

• How do you measure unrealized capital gains on an asset that is not regularly traded?

• Is the cost of an automobile used to drive to and from work a “cost of acquiring income?” Are child care expenses? Union Dues? Education expenses?

• How do you distinguish what part of an expense is a cost of acquiring income and what part is merely consumption?

Page 11: Public Finance: Taxes and Fiscal Policy

1. Income taxb) Corporate tax

Page 12: Public Finance: Taxes and Fiscal Policy

Forms of Business

• Sole Proprietorships• Partnerships• Corporations

– Corporations are granted the legal status of people. – This means that they can own property and borrow money

Page 13: Public Finance: Taxes and Fiscal Policy

Corporate Taxes

• Corporations are subject to a corporate income tax;• Since the corporation is not really a person, the

people who bear the burden of this tax depend on the shifting of the tax;

• The tax could be shifted backwards to employees, shifted forward to consumers or borne by the shareholders.

Page 14: Public Finance: Taxes and Fiscal Policy

The Tax Base: Measuring Business Income

• Using the comprehensive definition of income, business income is receipts + net capital gains income – labor, interest, material, and other business costs.

• Only realized capital gains are included in net taxable income for corporations.

Page 15: Public Finance: Taxes and Fiscal Policy

Taxation of Owner-Supplied Inputs

• In a small business setting, the owner works for him or herself. The profit from the business is what this owner is “paid.”

• Some of this is normal profit, some economic profit. • When there is a corporation there is no owner-

supplied input so all profit, normal and economic, is taxed.

Page 16: Public Finance: Taxes and Fiscal Policy

Corporate Profits and Where They Go

• Corporate Profits = Corporate Taxes + Retained Earnings + Dividends

• Retained Earnings are the portion of after-tax

corporate profits that a company keeps to invest in the business.

• Dividends are the portion of after-tax corporate profits that are distributed to households.

Page 17: Public Finance: Taxes and Fiscal Policy

Economic Depreciation

• Economic Depreciation is the amount that an asset devalues over time.

• When a business buys an expensive capital asset, it cannot deduct from corporate profits the entirety of the value of the asset.

• Because the asset will be productive for a substantial period of time, companies can only deduct a portion of the value of the asset.

Page 18: Public Finance: Taxes and Fiscal Policy

Accelerated Depreciation

• Accelerated depreciation allows businesses to deduct the loss in the value of an asset before it occurs.

• The ultimate in accelerated depreciation is the allowance for expensing an asset in the year it is purchased.

• Typically assets are allowed to be depreciated on a straight-line basis, which means in equal increments for the life of an asset.

Page 19: Public Finance: Taxes and Fiscal Policy

Double Taxation of Corporate Income

• Corporate Income is considered to be double-taxed because it faces taxes on the same income twice.

• The Corporation must pay taxes on the profits then the shareholders must pay taxes on the amount they receive in either dividends or capital gains.

• Under a comprehensive income tax this would not happen. Corporate profits, either retained or paid in dividends, would enter individual income tax structures according to the percentage of the corporation owned by each shareholder.

Page 20: Public Finance: Taxes and Fiscal Policy

Arguments in Favor of Double Taxing Corporate Income

• Unrealized Capital Gains and the Stepped-Up Basis: – A major source of unrealized capital gains for individuals is

corporate stocks. If the business profit were not taxed at the corporate level, it may never be taxed.

• Compensation for Bankruptcy Protection:– Individuals are not liable for the bankruptcy of assets they

hold in corporations whereas they are in cases of proprietorships and partnerships.

Page 21: Public Finance: Taxes and Fiscal Policy

The Consequence of Double Taxation: A Bias Toward Debt Finance

• A corporation can raise money by borrowing or it can raise money by selling stock.

• The corporation can deduct from its profits the amount it pays in interest to its bondholders.

• It cannot deduct the dividends it pays to its stockholders. This encourages debt finance over equity finance.

Page 22: Public Finance: Taxes and Fiscal Policy

Demonstrating the Bias toward Debt Finance

Item All-Equity 50% Debt – 50% Equity

Balance Sheet    

Total Assets $1,000,000 $1,000,000

Debt 0 $500,000

Shareholder’s Equity $1,000,000 $500,000

     

Income Statement    

Operating Income $150,000 $150,000

Interest Expense 0 $50,000

Taxable Income $150,000 $100,000

Income Tax $51,000 $34,000

Income after Corporate Tax

$99,000 $66,000

Return on Equity 9.9% 13.2%

Assumptions: 10% interest; 34 % tax rate

Conclusion: The taxation of corporate profits combined with the deductibility of interest raises the after-tax return on equity to firms in greater debt thereby motivating firms to increase their debt burdens to an inefficiently high level.

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2. Consumption and sales taxes

Page 24: Public Finance: Taxes and Fiscal Policy

Consumption as a Tax Base

• Consumption can be an alternative to income as a measure of ability to pay.

• Comprehensive consumption:

Income-SavingsNote that capital gains would not be taxed if it were not spent.

Page 25: Public Finance: Taxes and Fiscal Policy

Comparing a Tax on Income to a Tax on Consumption

Assumptions• Two equally situated persons with no physical capital • Wages = $30,000 per year • Interest rates = 10%• Flat rate tax for either consumption or income of 20%. • Two earning periods.

They have equal ability to pay taxes over their lifetime so they should pay equal taxes over their lifetime.

Page 26: Public Finance: Taxes and Fiscal Policy

Comparing a Tax on Income to a Tax on Consumption: Step 1 An Income Tax

• IA = IB = $30,000

• SA = 0

• SB = $5,000

• TA = $6,000 + $6,000/(1+.1)

= $6,000 + $5,455 = $11,455• TB = $6,000 + $6,100/(1+.1)/(1+.1)

= $6,000 + $5,545 = $11,545

Page 27: Public Finance: Taxes and Fiscal Policy

Comparing a Tax on Income to a Tax on Consumption: Step 2 A Consumption Tax for the Non-Saver

Income = Consumption + Consumption Tax +Savings First and Second Year• IA = CA + TA + SA

• $30,000 = CA + .2CA + 0• CA = $25,000 • TA = $5,000• SA = 0Present Value of All Taxes• TA = $5,000 + $5,000/(1+.1)

= $5,000 + $4,545.45 = $9,545.45

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Comparing a Tax on Income to a Tax on Consumption:Step 2 B Consumption Tax for the Saver

First Year

IB = CB + TB + SB

$30,000 = CB +.2CB + $5,000

CA = $20,583.33

TA = $4,166.66

SA = $5,000

Second Year

IB + Proceeds from Saving

= CB + TB

$35,500 = CB + .2CB

CA = $29,583.33

TA = $5,916.67Present Value of All TaxesTB = $4,166.66 + $5,916.67/(1+.1)

= $4,166.66 + $5,378.79 = $9,545.45

Page 29: Public Finance: Taxes and Fiscal Policy

Comparing a Tax on Income to a Tax on Consumption

• Under an Income tax, savers pay more in tax than non-savers.

• Under a consumption tax, they pay the same present value of taxes.

Page 30: Public Finance: Taxes and Fiscal Policy

Impact of a Sales Tax on the Efficiency in Labor Markets

• A substitution of a consumption tax for an income tax (with equal yields) would require a higher tax rate because of savings.

• The net efficiency change depends on whether the gain in the investment market is greater than the loss in the labor market.

• Estimates suggest such a change would have a positive impact on GDP.

Page 31: Public Finance: Taxes and Fiscal Policy

A Sales Tax

• A retail sales tax is typically a fixed percentage on the dollar value of retail purchases.

• Sales taxes are a major source of tax revenue for state and local governments. Some state rates are as high as 7% with local governments adding an additional 3% on top of that.

• Often food and medicine are exempt.

Page 32: Public Finance: Taxes and Fiscal Policy

An Excise Tax

• An excise tax is a selective tax on particular goods. • In Bulgaria excise taxes exist on alcohol, tobacco and

tobacco products, and energy resources (petrol, natural gas, oil, electricity).

Page 33: Public Finance: Taxes and Fiscal Policy

The Incidence of Sales and Excise Taxes

• Generally, sales taxes are regressive when food and medicine are not exempt.

• A national sales tax would be borne by labor income and would lack the progressive rate structure of the personal income tax.

Page 34: Public Finance: Taxes and Fiscal Policy

Turnover Taxes

• Turnover taxes are multistage taxes that are levied at some fixed rate on transactions at all levels of production.

• The effective rate of tax depends on the number of times the good is sold during the production process.

• This creates a significant bias toward vertical integration (where all production stays within the same firm).

Page 35: Public Finance: Taxes and Fiscal Policy

A Value-Added Tax

A value-added tax (VAT) is a consumption-based tax levied at each stage of production.

Value Added = Total Transactions – Intermediate Transactions

= Final Sales= GDP= Wages + Interest + profits + Rents + Depreciation

Tax Liability = Tax on Payable Sales – Tax Paid on Intermediate Purchases

= t(sales) – t(purchases)= t(sales – purchases)= t(value added)

Page 36: Public Finance: Taxes and Fiscal Policy

The VAT in Europe

• The VAT accounts for about 20% of EU member nation revenue.

• The average rates within the EU are between 15 and 20%.

• Different rates apply to different types of goods with luxury items facing the highest rate and necessities facing the lowest.

• The tax applies to services as well as goods.• Economists find the VAT a good alternative to an

income tax because it does less to discourage savings and investment.

Page 37: Public Finance: Taxes and Fiscal Policy

3. Property Taxes

Page 38: Public Finance: Taxes and Fiscal Policy

A Comprehensive Wealth Tax Base

• Real Property is property such as land and the structures on the land.

• Intangible Property is wealth that is held as paper or financial assets.

• Personal Property is wealth that is held in the form of cars, furniture, clothing, jewelry, etc.

Page 39: Public Finance: Taxes and Fiscal Policy

Measuring Wealth

• Market value can be used to establish the value of most real property and intangible property but personal property has no acceptable resale market.

• Serious inequities can arise from mismeasurement of wealth and serious shifting can take place when one form of wealth is taxed while another is not.

Page 40: Public Finance: Taxes and Fiscal Policy

Assessment of Property Value

• For the property tax, the assessed value of a home and the land upon which it sits is quite subjective. Real-estate markets exists for many homes but not others.

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4. Fiscal Policy

Page 42: Public Finance: Taxes and Fiscal Policy

Budget Deficits and Surpluses

• Budget deficit: Present when total government spending exceeds total revenue from all sources.• When the money supply is constant, deficits

must be covered with borrowing.• Governments borrow by issuing bonds.

• Budget surplus: Present when total government spending is greater than total revenue.• Surpluses reduce the magnitude of the

government’s outstanding debt.

Page 43: Public Finance: Taxes and Fiscal Policy

Budget Deficits and Surpluses

• Changes in the size of the deficit or surplus are often used to gauge whether fiscal policy is stimulating or restraining demand.

• Changes in the size of the budget deficit or surplus may arise from either: • A change in the state of the economy, or, • A change in discretionary fiscal policy.

• The budget is the primary tool of fiscal policy. • Discretionary changes in fiscal policy:

Deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.

Page 44: Public Finance: Taxes and Fiscal Policy

4. Fiscal Policya) The Keynesian view

Page 45: Public Finance: Taxes and Fiscal Policy

The Keynesian View of Fiscal Policy• Keynesian theory highlights the potential of fiscal

policy as a tool capable of reducing fluctuations in aggregate demand.

• Following the Great Depression, Keynesians challenged the view that governments should always balance their budget.• Rather than balancing their budget annually,

Keynesians argue that counter-cyclical policy should be used to offset fluctuations in aggregate demand.

• This implies that the government should plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.

Page 46: Public Finance: Taxes and Fiscal Policy

Keynesian Policy to Combat Recession

• When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy, by:• increasing the government’s purchases

of goods & services, and/or,• cutting taxes.

Page 47: Public Finance: Taxes and Fiscal Policy

AD1

• At e1 (Y1), the economy is below its potential capacity YF . There are 2 routes to long-run full-employment equilibrium:

Expansionary Fiscal PolicyPriceLevel

LRAS

YFY1

P2

AD2 Goods & Services

(real GDP)

Expansionary fiscal policy stimulates demand and directs the economy to

full-employment

SRAS1

P1

• Wait for lower wages and resource prices to reduce costs, increase supply to SRAS2 and restore equilibrium to E3, at YF.

SRAS2

P3

Keynesians believe thatallowing for the market to

self-adjust may be a lengthyand painful process.

e1

E2

• Alternatively, expansionary fiscal policy could stimulate AD (shift to AD2) and guide the economy back to E2, at YF .

E3

Page 48: Public Finance: Taxes and Fiscal Policy

Keynesian PolicyTo Combat Inflation

• When inflation is a potential problem, Keynesian analysis suggests a shift toward a more restrictive fiscal policy by:• reducing government spending, and/or,• raising taxes.

Page 49: Public Finance: Taxes and Fiscal Policy

AD1

• Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential YF.

Restrictive Fiscal PolicyPriceLevel

LRAS

YF Y1

P3

AD2 Goods & Services

(real GDP)

Restrictive fiscal policy restrains demand and helps control inflation.

SRAS2

P1

• If maintained, the strong demand will lead to the long-run equilibrium E3 at a higher price level (SRAS shifts to SRAS2).

SRAS1

P2

E3

• Restrictive fiscal policy could reduce demand to AD2 (or keep AD from shifting to AD1 initially) and lead to equilibrium E2.

e1

E2

Page 50: Public Finance: Taxes and Fiscal Policy

The Crowding-out Effect• The Crowding-out effect

– indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy.

• The implications of the crowding-out analysis are symmetrical. • Restrictive fiscal policy will reduce real interest

rates and "crowd in" private spending. • Crowding-out effect in an open economy:

Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

Page 51: Public Finance: Taxes and Fiscal Policy

Increase in budget deficit

Higher realinterest rates

Inflow of financial capital from abroad

Decline inprivate investment

Appreciation of the dollar

Decline in net exports

Crowding-Out in an Open Economy

• An increase in government borrowing to finance an enlarged budget deficit places upward pressure on real interest rates.

• This retards private investment and Aggregate Demand.• In an open economy, high interest rates attract foreign capital.• As foreigners buy more domestic currency to buy domestic bonds and

other financial assets, the domestic currency appreciates.• The appreciation of the domestic currency causes net exports to fall.• Thus, the larger deficits and higher interest rates trigger reductions in

both private investment and net exports, which limit the expansionary impact of a budget deficit.

Page 52: Public Finance: Taxes and Fiscal Policy

4. Fiscal Policyb) The New Classical view

Page 53: Public Finance: Taxes and Fiscal Policy

The New Classical View of Fiscal Policy

• The New Classical view stresses that:• debt financing merely substitutes higher future

taxes for lower current taxes, and thus, • budget deficits affect the timing of taxes, but not

their magnitude. • New Classical economists argue that when debt is

substituted for taxes:• people save the increased income so they will be

able to pay the higher future taxes, thus, • the budget deficit does not stimulate aggregate

demand.

Page 54: Public Finance: Taxes and Fiscal Policy

The New Classical View of Fiscal Policy• Similarly, New Classical economists believe that

the real interest rate is unaffected by deficits as people save more in order to pay the higher future taxes.

• Further, they believe fiscal policy is completely impotent – that it does not affect output, employment, or real interest rates.

Page 55: Public Finance: Taxes and Fiscal Policy

AD1

• New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes.

Expansionary Fiscal PolicyPriceLevel

Y1

Goods & Services(real GDP)

SRAS1

P1

• If households did not anticipate the higher future taxes, aggregate demand would increase (from AD1 to AD2).

• However, when households fully anticipate the future taxes and save for them, demand remains unchanged at AD1.

AD2

Page 56: Public Finance: Taxes and Fiscal Policy

Quantity of loanable fundsQ1

S1

Q2

Loanable FundsMarketReal

interestrate

r1

S2

D2

• To finance the budget deficit, the government borrows from the loanable funds market, increasing the demand (to D2).• Under the new classical view, people save to pay expected higher future taxes (raising the supply of loanable funds to S2.)

• This permits the government to borrow the funds to finance the deficit without pushing up the interest rate.

Expansionary Fiscal Policy

D1

Here, fiscal policy exerts no effect on the interest rate, real GDP, or unemployment.

e1 e2

Page 57: Public Finance: Taxes and Fiscal Policy

4. Fiscal Policyc) Changes and problems of timing

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Problems with Proper Timing

• There are three major reasons why it is difficult to time fiscal policy changes in a manner that produces stability:• It takes time to institute a legislative change.• There is a time lag between when a change is instituted & when it

exerts significant impact.• These time lags imply that sound policy requires knowledge of

economic conditions 9 to 18 months in the future. But our ability to forecast future conditions is limited.

• Discretionary fiscal policy is like a two-edged sword; it can both harm and help: • If timed correctly, it may reduce economic instability. • If timed incorrectly, however, it may increase economic instability.

Page 59: Public Finance: Taxes and Fiscal Policy

AD0

• Consider a market at long-run equilibrium E0 where only the natural rate of unemployment is present.

Timing of Fiscal Policy is DifficultPriceLevel LRAS

Y0Y1

AD1 Goods & Services

(real GDP)

P0

SRAS1

P1

E0

e1

• An investment slump and business pessimism result in an unanticipated decline in AD (to AD1). Output falls (to Y1) and unemployment increases.

Page 60: Public Finance: Taxes and Fiscal Policy

AD1

AD0

• After a time, policymakers consider and implement expansionary fiscal policy seeking to shift AD1 back to AD0.

• But it will take time to institute changes in taxes and expenditures. Political forces will slow this process.

Timing of Fiscal Policy is DifficultPriceLevel LRAS

Y0Y1

Goods & Services(real GDP)

P0

SRAS1

P1

E0

e1

Suppose that shifts in ADare difficult to forecast.

Page 61: Public Finance: Taxes and Fiscal Policy

AD0

• By the time a more expansionary fiscal policy is instituted and begins to exert its primary effect, private investment may have recovered and decision makers may therefore be increasingly optimistic about the future.

PriceLevel LRAS

Y0Y1

Goods & Services(real GDP)

P0

SRAS1

P1

AD2

E0

e1

• Hence, the more expansionary fiscal policy may over-shift AD to AD2.

AD1

Timing of Fiscal Policy is Difficult

Page 62: Public Finance: Taxes and Fiscal Policy

AD1

AD0

• The price level in the economy rises (from P1 to P2) as the economy is now overheating. Thus, incorrect timing leads to inflation.

PriceLevel LRAS

Y0Y1

P2

Goods & Services(real GDP)

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

Timing of Fiscal Policy is Difficult

E3

Page 63: Public Finance: Taxes and Fiscal Policy

AD0

• Alternatively, suppose an investment boom disrupts the initial equilibrium shifting AD out to AD2, and prices upward to P2.

PriceLevel LRAS

Y0

P2

Goods & Services(real GDP)

P0

SRAS1

E0

Y2

• Policymakers consider and eventually implement an increase in taxes and a cut in government expenditures.

Timing of Fiscal Policy is Difficult

AD2

e2

Page 64: Public Finance: Taxes and Fiscal Policy

• By the time the more restrictive fiscal policy takes affect, investment may have returned to its normal rate (shifting AD2 back to AD0).

PriceLevel LRAS

Y0

Goods & Services(real GDP)

P0

SRAS1

AD2

• In this case, the incorrect timing of the shift to the more restrictive fiscal policy to deal with potential inflation throws the economy into a recession (by over shifting AD to AD1).

Timing of Fiscal Policy is Difficult

P2 e2

Y2

AD1

Suppose that shifts in ADare difficult to forecast.

E0

AD0

Y1

P1 e1

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Why Timing of Fiscal PolicyChanges Are Difficult: A Summary

• Because fiscal policy does not work instantaneously, and since dynamic forces are constantly influencing private demand, proper timing of fiscal policy is not an easy task.

• Further, political incentives also influence fiscal policy. Public choice analysis indicates that legislators are delighted to spend money on programs that directly benefit their own constituents but are reluctant to raise taxes because they impose a visible cost on voters.• There is a political bias towards spending and budget

deficits. Predictably, deficits will be far more common than surpluses.

• Incorrectly timed policy changes may, them-selves, be a source of economic instability.

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Automatic Stabilizers• Automatic Stabilizers:

Without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom.

• The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action.

• Examples of automatic stabilizers:

Unemployment compensationCorporate profit tax A progressive income tax

Page 67: Public Finance: Taxes and Fiscal Policy

4. Fiscal Policyd) Supply-side Effects of Fiscal policy

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Supply-side Effects of Fiscal Policy• From a supply-side viewpoint, the marginal tax rate is of

crucial importance:A reduction in marginal tax rates increases the reward

derived from added work, investment, saving, and other activities that become less heavily taxed.

• High marginal tax rates will tend to retard total output because they will: discourage work effort and reduce the productive

efficiency of labor, adversely affect the rate of capital formation and the

efficiency of its use, and,encourage individuals to substitute less desired tax-

deductible goods for more desired non-deductible goods.

Page 69: Public Finance: Taxes and Fiscal Policy

Supply-side Effects of Fiscal Policy• So, changes in marginal tax rates, particularly high

marginal rates, may exert an impact on aggregate supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance.

• Impact of supply-side effects: Usually take place over a lengthy time period. There is some evidence that countries with high taxes

grow more slowly—France and Germany versus United Kingdom.

While the significance of supply-side effects are controversial, there is evidence they are important for taxpayers facing extremely high tax rates – say rates of 40 percent or above.

Page 70: Public Finance: Taxes and Fiscal Policy

AD1

• What are the supply-side effects of a cut in marginal tax rates?

Supply Side Economics and Tax RatesPriceLevel

LRAS1

YF2YF1

AD2

Goods & Services(real GDP)

With time, lower tax ratespromote more rapid growth

(shifting LRAS and SRASout to LRAS2 and SRAS2).

SRAS1

P0

SRAS2

E1

LRAS2

E2

• Lower marginal tax rates increase the incentive to earn and use resources efficiently. AD1 shifts out to AD2, and SRAS & LRAS shift to the right.

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

Page 71: Public Finance: Taxes and Fiscal Policy

Have Supply-siders Found a Way to Soak the Rich?

• Since 1986 the top marginal personal income tax rate in the United States has been less than 40% compared to 70% or more prior to that time.

• Nonetheless, the top one-half percent of earners have paid more than 25% of the personal income tax every year since 1997.

• This is well above the 14% to 19% collected from these taxpayers in the 1960s and 1970s when much higher marginal personal income tax rates were imposed on the rich.