Fiscal Policy. Government spending, tax, and budget balance Government Spending: G Government...

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Fiscal Policy

Government spending, tax, and Government spending, tax, and budget balancebudget balance

Government Spending: GGovernment Spending: G Government Revenue: TaxGovernment Revenue: Tax

Government spending, tax, and Government spending, tax, and budget balancebudget balance

Deficit = G - T Deficit = G - T

Two fiscal components in AE: Two fiscal components in AE: G and T G and T

AE = C + I + G + X - IMAE = C + I + G + X - IM

= a + b (Y - T ) + I + G + X - IM= a + b (Y - T ) + I + G + X - IM

TaxTax

Lump-sum TaxLump-sum Tax– is a fixed amount tax, regardless of the is a fixed amount tax, regardless of the

GDP level.GDP level. Income Tax Income Tax

– Depends on the income levelDepends on the income level

Lump-sum Tax and its effect on AELump-sum Tax and its effect on AE

A parallel shift in the AE lineA parallel shift in the AE line

Consumption function in the Y-C Space

Y (GDP)

C = ( a – bT) + b Y

a – bT

Changes in T

AE in the AE-Y space

AE = C + I + G + X - IM

cut in T

Example of a Model economy Example of a Model economy

C = 360 + 0.8 DIC = 360 + 0.8 DI

I = 300I = 300

G = 200G = 200

X - IM = 0X - IM = 0

T = 200T = 200 Assume that the potential GDP is Assume that the potential GDP is

40004000

Example of a Model economyExample of a Model economy

Assume prices are fixed, what is the Assume prices are fixed, what is the equilibrium level of Y?equilibrium level of Y?

AE =360+0.8(Y-200)+300+200+0 AE =360+0.8(Y-200)+300+200+0

= 0.8 Y + 700= 0.8 Y + 700

Y = AE = 0.8 Y + 700Y = AE = 0.8 Y + 700

(1-0.8) Y = 700(1-0.8) Y = 700

Y* = 1/(1-0.8) X 700 = 5 X 700 Y* = 1/(1-0.8) X 700 = 5 X 700

= 3500= 3500

Assume that the potential GDP is Assume that the potential GDP is 40004000

But the current output is 3500But the current output is 3500 Hence the recessionary gap is 500Hence the recessionary gap is 500

Cut in Tax (lump-sum tax)

Cut in T

Cut in Tax (lump-sum tax)

Cut in T

45 degree line

Y’Y*

Tax multiplierTax multiplier

Tax multiplierTax multiplierY* Y*

TT = ------ = ------TT

How big is the tax multiplier?How big is the tax multiplier?

ET MPCG

For the oversimplified versionFor the oversimplified version

MPCMPC

Effect of Tax Change on AEEffect of Tax Change on AE

The magnitude of shift in AE by a tax The magnitude of shift in AE by a tax cut is smaller as compared with cut is smaller as compared with increase in Gincrease in G

Why is smaller? Why is smaller? Leakage from savingLeakage from saving

ExampleExample

Suppose instead of increasing the Suppose instead of increasing the spending, the government decides to spending, the government decides to cut the tax to close the recessionary cut the tax to close the recessionary gap. By how much cut in tax can the gap. By how much cut in tax can the government close the gap?government close the gap?

Assume that the potential GDP is Assume that the potential GDP is 40004000

But the current output is 3500But the current output is 3500 Hence the recessionary gap is 500Hence the recessionary gap is 500 Objective: close this recessionary Objective: close this recessionary

gap to achieve the full employmentgap to achieve the full employment Two options: increase G or Cut in T.Two options: increase G or Cut in T.

Two options: increase G or cut in T.Two options: increase G or cut in T. If increase in G, how much?If increase in G, how much? If cut in T, how much?If cut in T, how much?

Increase in G.Increase in G. What is the expenditure multiplier?What is the expenditure multiplier? MPC = 0.8 so expenditure MPC = 0.8 so expenditure

multiplier is 5multiplier is 5 Increase G by 100 would lead to an Increase G by 100 would lead to an

increase in Y by 500, and close the increase in Y by 500, and close the recessionary gap.recessionary gap.

Cut in TCut in T What is the tax multiplier: -4What is the tax multiplier: -4

11 1 1 T = - MPC X --------- = - 0.8 X -------- = -4 T = - MPC X --------- = - 0.8 X -------- = -4

1 - MPC1 - MPC 1- 0.8 1- 0.8

To increase GDP by 500, we need tax cut byTo increase GDP by 500, we need tax cut by

500 / -4 = - 125 500 / -4 = - 125

Balanced budget multiplierBalanced budget multiplier

If the government If the government simultaneously increases its simultaneously increases its spending and tax by the same spending and tax by the same amount so as to leave the balance amount so as to leave the balance unchanged, will there be an impact unchanged, will there be an impact on the equilibrium GDP?on the equilibrium GDP?

--- a net effect on GDP--- a net effect on GDP

Income TaxIncome Tax

Depends on the income. It increases Depends on the income. It increases as income increasesas income increases

Income tax rate = tIncome tax rate = t Its effect on AEIts effect on AE

The slope of AE changes as tax The slope of AE changes as tax rate changesrate changes

Cut in in tax rate

increase in t

AEt = 0

t = 0.20

b ( 1-t)

Cut in tax rate

Cut in t

45 degree line

Y’Y*

Income TaxIncome Tax

Equation formEquation formLet the income tax rate = tLet the income tax rate = tTax isTax isT = tYT = tY

Consumption Consumption C = a + b DIC = a + b DI

= a + b (Y - tY)= a + b (Y - tY) = a + b (1-t) Y= a + b (1-t) Y

Example Example

ModelModel

C = 360 + 0.8 DIC = 360 + 0.8 DI

I = 300I = 300

G = 200G = 200

X - IM = 0X - IM = 0 With income tax rateWith income tax rate

t = 0.25t = 0.25

Income Tax ModelIncome Tax Model

Solve for equilibrium YSolve for equilibrium YC = 360 + 0.8 ( 1- 0.25 ) YC = 360 + 0.8 ( 1- 0.25 ) Y = 360 + 0.6 Y= 360 + 0.6 Y

AE = 360 + 0.6 Y + 300 + 200 AE = 360 + 0.6 Y + 300 + 200 = 860 + 0.6 Y= 860 + 0.6 Y

Notice that the slope of AE is flatter.Notice that the slope of AE is flatter. Y* = 1 / (1-0.6) X 860 Y* = 1 / (1-0.6) X 860

= 2.5 X 860 = 2150= 2.5 X 860 = 2150

Notice the expenditure multiplier Notice the expenditure multiplier becomes 2.5, which is smaller. becomes 2.5, which is smaller.

Income taxIncome tax

With income tax, the multiplier is With income tax, the multiplier is smaller because at each round of the smaller because at each round of the “trickling-down” process, there is a “trickling-down” process, there is a leakage of income tax paid.leakage of income tax paid.

This another reason why we called This another reason why we called 1/(1-MPC) oversimplified multiplier.1/(1-MPC) oversimplified multiplier.

Why changes in T is Why changes in T is less effective than Gless effective than G

in economic recessionin economic recession

Why changes in T is less effective Why changes in T is less effective than G in stimulating economy in than G in stimulating economy in economic recession?economic recession?

Tax multiplier is smallerTax multiplier is smaller Consumption is insensitive to a tax Consumption is insensitive to a tax

cut so long as people remain cut so long as people remain pessimistic about futurepessimistic about future

Difficulties to design a precise Difficulties to design a precise policy policy

All the variables are changing day by All the variables are changing day by day;day;

the precise value of MPC is unknown,the precise value of MPC is unknown, the precise value of Yp is unknown,the precise value of Yp is unknown, the time lag for the policy to take the time lag for the policy to take

effect is unknown,effect is unknown, the shape of AS is unknown thus the the shape of AS is unknown thus the

inflation side-effect caused by the inflation side-effect caused by the expansionary tax policy is unknown.expansionary tax policy is unknown.

Twin deficitsTwin deficits

The trade deficit is related to our The trade deficit is related to our budget deficitbudget deficit

We have $500 billion trade deficit, We have $500 billion trade deficit, and $1.5 trillion budget deficit.and $1.5 trillion budget deficit.

Breakdown of the deficit

Breakdown of the deficit• Compared with the October-June period of fiscal 2008, during the

first nine months of fiscal 2009: • --Revenues plunged $345 billion, or 17.8 percent; • --Spending soared $455 billion, or 20.5 percent; • --Defense spending increased 7.5 percent to $474 billion; • --Spending on food stamps increased 36.8 percent to $40 billion; • --Medicaid spending increased 23 percent to $186 billion; • --Unemployment benefits increased 165 percent to $77 billion; • --The Troubled Asset Relief Program, which began in October, has

cost taxpayers an estimated $147 billion; • --Bailing out Fannie Mae and Freddie Mac has cost $85 billion.

Twin deficitsTwin deficits

Y = C + I + G + (X - IM)Y = C + I + G + (X - IM) Y = C + S + TY = C + S + T

Combine the two accounting identities, we Combine the two accounting identities, we havehave

C + I + G + (X - IM) = C + S + TC + I + G + (X - IM) = C + S + T IM - X = (G – T) + (I – S) IM - X = (G – T) + (I – S) Trade deficitTrade deficit

= Government budget deficit = Government budget deficit

+net private saving deficiency+net private saving deficiency

How should we reduce trade deficitHow should we reduce trade deficit

Government budget deficit Government budget deficit

= net private saving + trade = net private saving + trade deficitdeficit

According to the twin deficits model, According to the twin deficits model, we need to reduce the government we need to reduce the government budget deficit G - Tbudget deficit G - T

You either cut the government You either cut the government spending or raising taxspending or raising tax

How should we reduce trade deficitHow should we reduce trade deficit

According to the Keynesian theory According to the Keynesian theory (the balance budget multiplier) (the balance budget multiplier) raising tax is probably the better idea raising tax is probably the better idea to balance the budget but stimulate to balance the budget but stimulate the economythe economy

But there is a big political hurdle to But there is a big political hurdle to raise tax.raise tax.

Health reform bill and budgetHealth reform bill and budget

According to the Congressional According to the Congressional Budget Office’s estimate, the bill will Budget Office’s estimate, the bill will cut the budget deficit by 138 billion cut the budget deficit by 138 billion dollars a year.dollars a year.

CBO is a non-partisan, independent CBO is a non-partisan, independent office, reporting to the Congress. office, reporting to the Congress. The Republicans also cite often the The Republicans also cite often the figures by CBO to criticize figures by CBO to criticize Democrats.Democrats.

Supply-side economicsSupply-side economics

ReaganomicsReaganomics Supply-side economicsSupply-side economics Supply-side tax cutsSupply-side tax cuts Shift focus from AD to ASShift focus from AD to AS

Supply-side economicsSupply-side economics

Supply-side tax cutsSupply-side tax cuts cutting income tax to induce people cutting income tax to induce people

to work longer, and to work longer, and giving tax incentive to encourage giving tax incentive to encourage

investment and researchinvestment and research RemarksRemarks

Fiscal Policy. Government spending, tax, and budget balance Government Spending: G Government...

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