Ch. 10: Fiscal Policy Del Mar College John Daly ©2003 South-Western Publishing, A Division of Thomson Learning.

Ch. 10: Fiscal Policy

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Fiscal Policy

• Refers to changes in government expenditures and/or taxes to achieve particular economic goals, such as low unemployment, price stability, and economic growth.

• Government expenditures is the sum of government purchases and transfer payments.

Fiscal Policy Definitions

• Expansionary fiscal policy refers to increases in government expenditures and/or decreases in taxes to achieve macroeconomic goals.

• Contractionary fiscal policy attempts to decrease government expenditures and/or increases in taxes to achieve macroeconomic goals.

Fiscal Policy Definitions

• Discretionary Fiscal Policy is deliberate changes of government expenditures and/or taxes to achieve particular economic goals.

• Automatic Fiscal Policy is changes in government expenditures and/or taxes that occur automatically without (additional) congressional action.

Two Key Assumptions

• In our discussion of fiscal policy, we only deal with discretionary fiscal policy.

• We assume that any change in government spending is due to a change in government purchases and not to a change in transfer payments.

Demand-Side Fiscal Policy

• A change in consumption, investment, government purchases, or net exports can change aggregate demand and there fore shift the AD curve.

• A change in taxes can affect consumption or investment or both and there for can affect aggregate demand.

Fiscal Policy: A Keynesian Perspective

Crowding Out

• Refers to a decrease in private expenditures that occurs as a consequence of increased government spending or the financing needs of a budget deficit.

• Economists who believe the crowding out phenomenon exists argue that because of the direct substitution of public services for consumer spending or because of higher interest rates, increases in government spending induce consumers and investors to spend less.

Crowding Out• Complete Crowding Out occurs when the decrease

in one or more components of private spending completely offsets the increase in government spending.

• Incomplete Crowding Out occurs when the decrease in one or more components of private spending only partially offsets the increase in government spending.

• If complete or incomplete crowding out occurs, it follows that expansionary fiscal policy will have less impact on aggregate demand and Real GDP than Keynesian theory predicts.

Keynesian Theory & Crowding Out

• In Keynesian theory, expansionary fiscal policy shifts the aggregate demand curve to AD2 and moves the economy to point 2.

• If there is no crowding out, expansionary fiscal policy increases Real GDP and lowers the unemployment rate.

• If there is incomplete crowding out, expansionary fiscal policy increases Real GDP and lowers the unemployment rate, but not as much as in the case of zero crowding out.

• If there is complete crowding out, expansionary fiscal policy has no effect on the economy.

The New Classical View of Fiscal Policy: Crowding Out with No

Increase in Interest Rates• Individuals respond to expansionary fiscal policy, a larger

deficit, and greater deficit-financing requirements by thinking the following “A larger deficit implies more debt this year and higher future taxes. I’ll simply save more in the present so I can pay the higher future taxes required to pay interest and to repay principal on the new debt. But, of course, if I’m going to save more, I’ll have to consume less.

1. Current consumption will fall as a result of expansionary fiscal policy.

2. Deficits do not bring higher interest rates.

The New Classical View of Expansionary Fiscal Policy

• As long as expansionary fiscal policy is translated into higher future taxes, there will be no change in Real GDP, unemployment, the price level, or interest rates.

Lags And Fiscal Policy

1. The Data Lag2. The Wait-And-See Lag3. The Legislative Lag4. The Transmission Lag5. The Effectiveness Lag

Some economists argue that discretionary fiscal policy is not likely to have the impact on the economy that policymakers hope. By the time the full impact of the policy is felt, the economic problem it was designed to solve may no longer exist, may not exist to the degree it once did, or it may have changed altogether.

Lags And Fiscal Policy

The government has moved the economy from point 1 to point 2, and not, as they had hoped, from point 1 to point 1’.

Demand-Side Fiscal Policy: Return to the Keynesian Model

It would seem that under the conditions of no lags and zero crowding out, expansionary fiscal policy – either increasing government spending or cutting taxes – will work at removing the economy from a recessionary gap.

Demand-Side Fiscal Policy: Return to the Keynesian Model

If government knows the difference between Q1 and QN (so that it knows how much to change Real GDP) and it knows the MPC, then it can use fiscal policy to get the economy out of a recessionary gap and producing Natural Real GDP.

Demand-Side Fiscal Policy: Return to the Keynesian Model

• If the government doesn’t know the actual MPC and it doesn’t know the actual difference between Q1 and QN, then fiscal policy isn’t likely to work as intended.

Tax Cuts Instead: Are Things Any Different?

• An important equation: Real GDP = -MPC(m) x T• A dollar spend by government is a dollar

spent; a dollar tax cut is a dollar partly saved and partly spent. In order to get the same change in Real GDP, government has to cut taxes more than it has to raise purchases.

Q & A

• How does crowding out question the effectiveness of expansionary demand-side fiscal policy?

• Do budget deficits raise interest rates?

• How can an increase in the size of the federal budget deficit affect the trade deficit?

Supply-Side Fiscal Policy

• All other things held constant, lower marginal tax rates increase the incentive to engage in productive activities relative to leisure and tax avoidance activities.

• Marginal Tax Rate = (Δ Tax payment)/(Δ Taxable Income)

• Given a cut in marginal tax rates two things will happen: Individuals will have more disposable income; the amount of money they can earn by working increases.

• In the analysis of marginal tax rates and aggregate supply, we implicitly assume that in the aggregate, a marginal tax rate cut increases work activity.

The Predicted Effect of a Permanent Marginal Tax Rate Cut on Aggregate

Supply

The Laffer Curve: Tax Rates and Tax Returns

• If income tax rates were lowered, would it increase or decrease tax revenue?

• There are two tax rates at which zero tax revenues will be collected – 0 and 100%.

• An increase in tax rates could cause tax revenues to increase.

• A decrease in tax rates could cause tax revenues to increase.

• Tax revenues = (Tax base) x (the average Tax rate)

The Laffer Curve: Tax Rates and Tax Returns

The Laffer Curve: Implications• We assume that as the tax rate is reduced, the tax

base expands. The rationale is that individuals work more, invest more, and enter into more exchanges, and shelter less income from taxes and lower tax rates.

• How much does the tax base expand following the tax rate reduction?

• Tax revenues increase if a tax reduction is made in the downward-sloping portion of the curve (between points B and C); tax revenues decrease following a tax rate reduction in the upward sloping portion of the curve (between points A and B).

Macroeconomics Intermission

How Does the Economy Work?– Is it Self-regulating?

– Is it Inherently unstable?

– Will a fiscal policy have its intended effect?

Q & A

• Give an arithmetical example to illustrate the difference between the marginal and average tax rates.

• If income tax rates rise, will income tax revenue rise as well?