The Federal Budget and Fiscal Policies

Federal Budget

Fiscal Policy

Supply-side Policy

Fiscal Policy

n The deliberate manipulation of laws authorizing government spending (G) and laws governing taxes (T) for the purpose of “fixing” the economy.

n Government changes G and T to “fix” the Economy.

The Federal Budget

n The annual fiscal budget includes:

n $ in: tax revenues (T)

n $ out: government spending (G)

n Surplus: G – T < 0

n Balanced: G – T = 0

n Deficit: G – T > 0

n Deficit spending is the usual case.

Government Expenditures (G) and Receipts (T)

Government Expenditures (G)

n $2.5 trillion in 2005.

n Spent on:

n Social Security - $519B

n Medicare - $333B

n Medicaid - $182B

n National Defense - $500B

n Interest on the Public Debt - $177B

n Other programs

Government Expenditures (G)

n Generalizing:

n Payments for goods and services, including the government payroll

n Transfer payments

Transfer Payments

n Transfer payments shift purchasing power from one group to another

n Usually, from taxpayers (income earners) to groups currently favored by government:

n Welfare receivers

n Subsidy receivers

n Special-interest groups

Taxation

n $2.15 trillion in 2005.

n Governments produce no wealth or income.

n Primary purpose of taxation:

n Shift income (purchasing power) from the private sector to the public sector.

Sources of Taxes

n Federal:

n Individual Income Tax - $927B

n Corporate Income Tax - $278B

n Social Security Tax - $798B

n States and Local:

n Property Tax

n Sales Tax

Who Pays the Income Tax?

Opportunity Cost of Taxes

n The income a person uses to pay taxes has alternative uses that must be foregone.

n Whatever the taxpayer would have chosen to do with the income that is taxed away is the opportunity cost of taxation.

Marginal Tax Rate (MTR)

n For each added unit of income, MTR is the percent due in taxes

n MTR = ΔT/ ΔY

n The Federal income tax brackets are marginal tax rates

n People make earning decisions based on their MTR.

Progressive tax

n Makes people with high incomes pay a larger percent of their income in taxes than those with lower incomes.

n The tax rate rises as income rises, and vice versa.

n Example: Federal income tax

Federal Income Tax Schedule - Single

Federal Income Tax Schedule – Single: Example

Regressive tax

n Makes people with low incomes pay a larger percent of their income in taxes than those with higher incomes.

n The tax rate falls as income rises, and vice versa.

n Examples: Payroll tax (FICA), sales tax (with no exemptions), property tax.

Proportional Tax

n People at each level of income pay the same percent of their income in taxes.

n The tax rate stays the same as income rises, and vice versa.

n Example: none (maybe a pure “flat tax”)

What’s the difference?

n In each of the tax structures, the higher income person pays more dollars in tax than the lower income person.

n The difference between progressive and regressive taxes is the percent of income taken in tax.

Fiscal Policy

n Government manipulates changes in G and in T to shift AD.

n Move the economy toward full-employment.

n Close the “gap”.

n This is done by the Congress and the President agreeing to changes in laws affecting G and T.

Underperforming Economy: Closing a Recessionary Gap

n Expansion Fiscal Policy

n “Jumpstart”:

n Increase G, or

n Decrease T.

n The multiplier effect finishes the job.

n Start with a deficit, G – T < 0

n fighting a recession will make the deficit bigger.

Causing and “Fixing” an Underperforming Economy

How much fiscal policy using G?

n Final change in GDP =

n (initial change in G) x (spending multiplier)

n Example:

n Recessionary gap = $24 billion

n MPC = ¾, so MPS = ¼ and spending multiplier = 4

n Increase G by $6 billion

How much fiscal policy using T?

n Final change in GDP =

n (initial change in T) x (tax multiplier)

n Example:

n Recessionary gap = $24 billion

n MPC = ¾, so MPS = ¼, spending multiplier = 4, so tax multiplier = -3

n Decrease T by $8 billion

Overheated Economy: Closing an Inflationary Gap

n Contraction Fiscal Policy

n “Jumpstart”:

n Decrease G, or

n Increase T.

n The multiplier effect finishes the job.

n Start with a deficit, G – T < 0

n fighting inflation will make the deficit smaller.

Causing and “Fixing” An Over-
Heated Economy

How much fiscal policy using G?

n Final change in GDP =

n (initial change in G) x (spending multiplier)

n Example:

n Inflationary gap = -$12 billion

n MPC = ¾, so MPS = ¼ and spending multiplier = 4

n Decrease G by $3 billion

How much fiscal policy using T?

n Final change in GDP =

n (initial change in T) x (tax multiplier)

n Example:

n Inflationary gap = -$12 billion

n MPC = ¾, so MPS = ¼, spending multiplier = 4, so tax multiplier = -3

n Increase T by $4 billion

Fiscal Policy Affects the Deficit

n Government budget = T – G

n If G > T, deficit spending

n borrowing required to get funds to pay the bills

n “crowds out” private sector borrowers

n Expansion policy: deficit increases

n Contraction policy: deficit decreases

Caution!

n Congress and the President change tax laws and government spending appropriations for reasons other than “jumpstarting” the economy.

n ANY change in G or T, for whatever reason, will affect AD and the economy.

Caution!

n Excessive increases in G or decreases in T will move the economy toward an inflationary gap. Greater deficits, too.

n Excessive decreases in G or increases in T will move the economy toward a recessionary gap.

Caution!

n Time Lags: It takes time to implement fiscal policy!

n Recognize the problem.

n Debate, devise and agree to a “fix”.

n Allow time for the multiplier process to work.

n Usually, the “fix” goes into full effect after self-regulation has “fixed” the problem.

The Politics of Fiscal Policy

n Political bickering.

n “Small” government officials want to decrease G or decrease T.

n They believe government programs are too large, too costly, and too inefficient and that the private sector can solve problems better.

n “Big” government officials want to increase T or increase G.

n They believe more and larger government programs are needed to solve problems.

Automatic stabilizers

n Existing laws go into effect immediately to counteract the GDP trend

n Income tax withholding law

n Unemployment compensation law

Automatic stabilizers

n Recession begins:

n People are laid off (unemployment rises)

n Income tax withholding falls (T decreases)

n Unemployment compensation payments increase (G increases)

n Decreasing T and increasing G fight recession

n The opposite occurs as recovery begins

Deficits and Debt

n Every year’s deficit must be covered by increased government borrowing.

n This removes funds from the credit market.

n These funds would have been borrowed by consumers and businesses.

n Their economic activity is reduced.

n This is called “crowding out”.

Deficits and Debt

n The added borrowing adds to the nation’s debt, which now exceeds $7 trillion.

n As debt increases, so do interest payments on the debt.

n This uses up tax dollars that cannot be used for anything else.

Supply-Side Policy

n Government’s goal: Shift SRAS to the right.

n Increase incentive to produce.

n Increase incentive to invest, innovate and modernize.

n Increase incentive to work harder and take entrepreneurial risk.

n Side effects:

n Ultimately, both AD and LRAS will also shift to the right.

n Government should never plan to shift SRAS to the left.

Adverse Supply-Side Policy

n Shifts AS left.

n inflation rises

n unemployment rises

n economy stagnates

n Government could cause by:

n raising production costs

n raising taxes

n disincentives to produce

n excessive government intrusion in business

Supply-Side Policy

n Expand the capability and desire to produce.

n Lower business taxes.

n Reduce the cost of compliance with government regulation.

n Lower other costs of operating or establishing a business.

Evolution of Supply-Side Policy

n Keynes’ policies focus on AD only.

n AD right?

n Unemployment falls

n Inflation rises

n AD left?

n Unemployment rises

n Inflation falls

n Basis for “fine tuning”

The 1960’s

n SRAS did not shift.

n Government could choose which combination of inflation and unemployment was politically acceptable.

n Called “fine tuning”

n Done by shifting AD

n Fiscal policy was the preferred policy.

Evolution of Supply-side Policy

n “Fine Tuning”

n Select a politically acceptable mix of inflation and unemployment

n How? Shift AD left or right to find it

n In the 1960’s, Phillips Curve showed this could be done easily.

The Phillips Curve

n Inverse relationship between inflation and unemployment

n Implication:

n As a policy move, you can “trade off” some higher inflation for lower unemployment, and vice versa

The Phillips Curve in the 1960s

The Phillips Curve

n The inverse relationship disappeared in the 70s:

n Stagflation

n Inflation increased and

n Unemployment increased

Phillips Curve, 1960s to the Present

n The Phillips Curve shifted right twice in the 1970s, then left in the 1980s and left again in the 1990s.

The Phillips Curve

n Conclusion: Fine-tuning no longer worked. Why?

n In the 60s, SRAS did not shift

n In the 70s, SRAS shifted left

n What policy could work?

n Shift SRAS right

n That occurred in the 80s and 90s

1970’s

n SRAS shifted to the left.

n Phillips curve shifted to the right.

n “Fine tuning” no longer worked.

n Triple “bads”:

n Unemployment increased.

n Inflation increased.

n Real GDP decreased.

1970’s

n Supply-side’s proposed response:

n To “fix” SRAS shifting left, government should take actions to shift SRAS right.

n This also would shift the Phillips Curve to the left.

n Actions would lower both inflation rate and unemployment rate

What government policies?

n Create incentives to:

n Earn more

n Work harder and longer

n Improve work skills

n Invest in new plant and equipment

What government policies?

n Eliminate excessive regulatory costs

n Deregulate industries

n Decrease business taxes

n Reduce individual tax rates

n Reduce taxes on investment income

Comparing the 1970’s with the 1980’s and 1990’s

n 70s: SRAS shifts left and Phillips Curve shifts right.

n Oil “shocks”

n Excessive government regulation

n Higher taxes on businesses

n Higher taxes on individuals

n 80s and 90s: SRAS shifts right and Phillips Curve shifts left

n Business tax cuts

n Personal tax cuts

n Deregulation

n Technological revolution and innovation

n Productivity gains

Evolution of Supply-Side Policy

n Abandon “fine-tuning”

n Focus on shifting SRAS right

n The policies to shift SRAS right are the same that encourage long run growth

Supply-Side Policy

n If Congress and the President change the marginal tax rates, instead of just manipulating tax revenues (T), this action will shift SRAS.

n Lower tax rates = greater incentive to produce and SRAS shifts right.

n Higher tax rates = reduced incentive to produce and SRAS shifts left.

Supply-Side Tax Policy

n Income taxes punish earning an income

n Business taxes punish success in business

n High tax rates encourage tax avoidance and unproductive activity

n Only the “rich” can do this

Will Raising Taxes Punish the “Rich”?

n The “rich” will increase their efforts to avoid paying the added taxes:

n Hire tax lawyers and accountants

n Lobby for tax shelters and loopholes

n The “non-rich” cannot afford to do these things, so:

n They just pay more taxes

The case for lower tax rates

n The Laffer curve relates marginal tax rates and tax revenues (T)

The case for lower tax rates

n High incomes: Lower the marginal tax rates and tax revenue increases

The case for lower tax rates

n Low incomes: Lower the marginal tax rates and tax revenue decreases

Laffer Curve: the 1980’s

n Marginal tax rates were reduced for all taxpayers.

n High income earners:

n Top tax rates decreased from 70% to 33%.

n Tax revenues they paid increased 51% (top side of the Laffer curve).

Laffer Curve: the 1980’s

n Lower income earners:

n Their marginal tax rates decreased also.

n Tax revenues they paid decreased 8.5% (bottom side of Laffer curve).

Did the Tax Cuts in the 1980s Cause Huge Deficits?

n Tax revenues (T) doubled from $517 billion to $1032 billion in the 1980s.

n …but, Government spending (G) tripled during the 1980s.

n Why, then, did the deficit increase?

The Bush tax cuts

n In 2003:

n Rates on dividends dropped from 39.6% to 15%

n Rates on capital gains dropped from 20% to 15%

n Investment spending increased 22% since 2003

The Bush tax cuts

n Lower income tax rates were made effective in 2003.

n From 2004 to 2005:

n Federal tax revenues rose $187 billion (15.4%)

n State tax revenues increased 7.5%.

n Budget deficit fell by $77 billion.

The case for lower taxes

n Increasing business taxes: a disincentive to produce

n Increasing income taxes: a disincentive to earn

n Reducing taxes stimulates:

n Production

n Employment

n Investment

n Innovation

The case for lower taxes

n SRAS shifts right, followed by AD shifting right

n Fixes short-run economic problem

n LRAS shifts right

n Economic growth occurs

n PPF pushes outward

Taxes, AD, and SRAS

n Increase tax rates:

n AD shifts left

n SRAS shifts left

n LRAS (economic growth) stagnates

n Decrease tax rates:

n AD shifts right

n SRAS shifts right

n LRAS (economic growth) shifts right

How do People React to a Tax Change?

n Increase the tax rates?

n immediately, taxpayers pay more taxes on the same income, so tax revenues rise

n ultimately, taxpayers’ taxable income falls as they take action to shelter income from taxes, and tax revenues fall.

n But only the “rich” can afford to do so.

n Middle incomes and “poor” just pay more taxes.

How do People React to a Tax Change?

n Reduce tax rates?

n immediately, taxpayers pay less taxes on the same income, so tax revenues fall

n ultimately, taxpayers’ income rises as they work more/harder, and tax revenues rise.

n This would apply to all levels of income.

The J-Curve Effect: Tax Rate Decrease

The J-Curve Effect: Tax Rate Increase

The J-Curve Effect

n Politicians are short-sighted. They believe:

n To raise tax revenues, raise tax rates.

n True in the short-run, false in the long-run.

n If tax rates are reduced, tax revenues will fall and the budget deficit will increase.

n True in the short-run, false in the long-run.

What Really Happened in the Great Depression?

n Did self-regulation just stop working?

n 1920’s: economic prosperity

n 1929: the peak was reached and a recession began

What Really Happened in the Great Depression?

n From 1929 to 1932:

n Poor government policies worked against self-regulation.

n High tariffs ruined international trade

n … and began the stock market crash.

n Taxes were increased to balance the budget.

n The Fed kept money policy tight.