UNIT V: FISCAL POLICYWhat can the government

do to help fight the economic enemies of

Recession/Depression and Inflation?

Part I: Fiscal PolicyPart II: TaxesPart III: Debt

Part I: Fiscal Policy

What is fiscal policy?It’s the

government’s power to TAX AND SPEND in order to regulate the economy

The fiscal year runs from October 1 to September 30

Where does fiscal policy come from?

1936: John Maynard Keynes develops his “General Theory” in his book The General Theory of Employment, Interest, and Money.

Why does the actual production in an economy sometimes fall short of its productive capacity?

Thus was born the Keynesian Revolution

2 Ways to be an Economist:

Classical Keynesian

Classical:

Economy will have its ups & downs (a general flow)

Keep gov’t out of business; leave it along

Things will work themselves out…

Keynesian:

John Maynard Keynes said economy was more like an elevator

If elevator is stuck, you need to intervene (emergency buttons?!)

Increase spending to stimulate demand

Who was John Maynard Keynes?

Gov’t advisor, teacher, journalist

Revolutionized economic theory

Influenced wartime and post-war economic policy

New Deal Economics: Demand Side Economics/(Keynesian)

Keynesian vs. Classical Economics

Keynesian Classical

Examines the productive

capacity of the economy as a

wholeNo self-correcting

method!!!!!!!!!The answer:

SPENDFDR agreed!

Examined theequilibrium of

supply and demand forindividual products

Fiscal Policy and Aggregate Demand

Fiscal policy will regulate aggregate demand

What is aggregate demand?

How is aggregate demand calculated? THE TARGET:

AGGREGATE DEMAND

AND/OR….increase or decrease the government’s spending (g)

Demand-Side Economics

Supply-Side Economics

Lower taxes for consumers

which will in turn increase

the purchasing power of the

consumer(Keynesian)

Lower taxes for businesses to

encourage industries to

invest(increases aggregate

supply)

The Government’s Role

Expansionary Contractionary

Increase government

spending or cut taxes to increase

demand

Output Employment

Decrease spending or raise taxes to

decrease or slow demand

Why? When demand exceeds supply, producers must choose between raising output or

raising prices

Type of fiscal policy

Change in government

spending

Change in taxes

Expansionary

And/Or

Contractionary

And/Or

Types of Fiscal Policy

How can we stabilize the economy?

Discretionary StabilizersAutomatic Stabilizers

◦The deliberate manipulation of taxes & gov’t spending by Congress – (government makes/changes laws) Increase/Decreases taxes & spending

Policy change happens by itself as the economy changes

◦Unemployment Compensation

◦Progressive Income Taxes

Discretionary Policies:

I. EXPANSIONARY:◦Why? Jumpstart the economy by stimulating

demand

◦How? Increase gov’t spending Decrease taxes

◦When Used? During a recession

Effects of Expansionary Fiscal Policy

Total output in the economyHigh outputLow output

High prices

Low prices

Pri

ce

le

ve

l

Aggregate supply

Original aggregate demand

Lower output, lower prices

Higher output, higher prices

Aggregate demand with higher government spending

Expansionary Fiscal PoliciesIncreasing Government

Spending If the federal govt

increases its spending or buys more goods & services, it triggers a chain of events that raise output & creates jobs.

Cutting TaxesWhen the govt cuts

taxes, consumers & businesses have more money to spend or invest. This increases demand & output.

CONTRACTIONARY:◦Why?

“cool” down economy Slow down demand

◦How? Decrease spending Increase taxes

◦When? Inflationary Times

Discretionary Policies:

Effects of Contractionary Fiscal Policy

Total output in the economyHigh outputLow output

High prices

Low prices

Pri

ce

le

ve

l

Aggregate supply

Higher output, higher prices

Original aggregate demandLower output,

lower prices

Aggregate demand with lower government spending

Contractionary Fiscal PoliciesDecreasing Government

Spending If the federal govt

spends less, or buys fewer goods & services, it triggers a chain of events that may lead to slower GDP growth.

Raising Taxes If the federal govt

increases taxes, consumers & businesses have fewer dollars to spend or save. This also slows growth of GDP.

The Effectiveness of Fiscal Policy

Objective Policy Condition existing

Does the policy affect

total spending in

the economy?

Does the policy meet the

objective (as stated in the 1st

column)?

Reduce unemploym

ent

Expansionary fiscal

policy (as measured

by an increase in

govt spending)

No crowding

outYES YES

Complete crowding

outNO NO

Incomplete Crowding

outYES YES

Reduce inflation

Contractionary fiscal policy (as measured

by an decrease in

govt spending)

No crowding

inYES YES

Complete crowding

inNO NO

Incomplete Crowding

inYES YES

Part II: Taxes

Why do we pay taxes?

What kinds of taxes are there?

Federal Income Tax (W-2, W-4, etc.)

Excise TaxesEstate TaxesFICACapital Gains

TaxesCorporate

Income Taxes

What is a “Fair Tax”?

1. It is proportional to income

2. It is clear and comprehendible

3. It is economically efficient

4. It is flexible

George W. Bush’s Tax Plan(2001-2010)

Lowered taxes across the board (25-35%)

Eliminated the marriage penalty

Increased yearly IRA contributions

Increased the child credit

MORE DISPOSABLE INCOME!!!

What is the “Flat Tax” Proposal?

Flat tax of 17% on all Americans

No Deductions (except children)

Family of 4 would have to earn $36,800 before income tax

Armey-Shalby Tax: Freedom and Fairness Restoration Act

3 Kinds of Effective Tax Rates

-Progressive Tax: tax rate increases as a person’s income goes up (income tax)

Proportional Tax: tax rate remains the same regardless of income (FICA)

Regressive Tax: tax rate “decreases” as income goes up. (Larger proportions of earnings come from people with lower incomes)

Effective Tax Rate: The % of your income you pay in

taxes

Engels LawErnst Engel, German Statistician

The lower a family’s income, the greater the % the family has to spend on the necessities of life.

Proportional taxes are a burden to lower income families

Part III: Budgets, Deficits, and Surpluses

Why would we spend money we don’t have?

War today = Freedom tomorrowInterest rates on U.S. savings bonds,

Treasuries, etc. go back to Americans-for the most part

Multiplier Effect! Expansion = More Expansion

Technology for future (AJH 2013)It is part of our social obligation to

take care of the less fortunate (Medicare, Medicaid, Head Start, etc.

Why should we avoid deficit spending?

Passing on the debt to future generations

It fuels inflationNational Security Risk: 47% of

our national debt is owed to foreigners

Deficit spending increases our national debt

13 cents/$1.00 goes to paying off the interest on our national debt!

What is the national debt?National debt is the

accumulated deficits that add up over the years

Why the Government has a dilemma…

Policies that are put into place to bring down inflation will also increase unemployment

The Phillips Curve?Why is lowering inflation problematic for achieving our economic goals?

Who pays for the cost of running the government?

Budget Levels:1.Federal (U.S.)2.State 3.Local

1.All levels must develop budgets with taxes and spending in mind.

Budget TermsSurplus Budget: revenues exceed expenditures

Deficit Budget: expenditures exceed revenues

Fiscal Year: October 1 - September 30th

How do budgets get “bloated”?“Earmarks” – many

Congressional representatives hold major revenue bills hostage with “earmarks” for their home districts

“Pork Barrel Legislation”

What if the deficit starts going down?

BE WORRIED!!!!!!!!78 Millions Baby Boomers will soon need:

- Social Security -Medicare -Medicare will pay more this year than it

will take in-Social Security will pay out more than it

takes in 2017

Historical Efforts to Cut the Budget

Gramm-Rudman Hollings Act

Balance Budget Amendment

(1995)Limit deficit to

$100 bil in 1990Limit deficit to

$64 bil in 1991Limit deficit to

$28 bil in 1992Balance budget

by 1993

Required federal budgets to be balanced before they became law

Failed by one vote in the Senate

Who prepares the Budget?OMB: Office of

Management and Budget in Executive Office

Congress has the final say

Most likely, the budget that gets passed will be very different from the one the president proposed.

The Federal Budget

Q: What is the single largest federal expenditure?

A: Entitlement Programs

Q: What is the largest single source of revenue?

A: Federal Income Tax

The State Budget

Q: What is the largest source of revenue for the state?

A: Sales Tax

Q: What is the largest expenditure on the state level?

A: Education (Social Security is #2)

The Local Budget

Q: What is the largest source of revenue on the local level?

A: Property Taxes

Q: What is the largest expenditure on the local level?

A: School Budget