Fiscal Policy

Fiscal Policy

Fiscal Policy is changes in federal spending and taxes to achieve macroeconomic objectives; price stability (mostly pursued by the FED, not the Gov’t), economic growth, and full employment.

1946 Full Employment Act – To “promote maximum employment, production, and purchasing power.“

Fiscal – Latin for “treasury”, but originally for “purse or basket”.

Automatic Stabilizers vs. Discretionary Spending

Automatic Stabilizers are government spending and taxes policies that automatically decrease or increase in a countercyclical manner.

When the economy is expanding, spending on unemployment insurance goes down and taxes go up due to rising incomes. Therefore, we have a decrease in G and an increase in T automatically, helping to curb any overheating in the economy.

During recessions, unemployment benefits increase and taxes decrease automatically, helping to stimulate the economy and mitigate the recession.

Discretionary Spending vs. Mandatory Spending

Discretionary Spending – Spending that is controlled by Congress and the President from budget to budget.

National Defense, housing, NASA, education and science, transportation, foreign aid, the EPA.

Mandatory Spending – Spending enacted by laws and cannot be changed unless the law changes.

Social Security, Medicare

Trends in Federal Spending as a Percentage of GDP

1787 - 1849: 1.7% of GDP 1850 – 1900: 3.1%, including the Civil War 1901 – 1930: 4.7%, but as high as 17.2% and 24.2%

during 1918 and 1919, respectively 1931 – 1941: 9.3% 1942 – 1945: 39.4% during WWII 1946 – 1959: 18.3 % 1960 – 2010: 19.9%Since 1947, U.S. government spending has been roughly stable between 16% and 25% with a very slight trend upward. From 1960, there is no discernible trend with spending fluctuating between 18% and 25%.

Trends in Federal Spending as a Percentage of GDP

Even though federal spending has increased over the years, federal purchases on goods and services has declined as a percentage of GDP since 1954 from roughly 17% to roughly 5%.

Federal Gov’t Purchases of G&S and Total Federal Expenditure as a Percent of GDP

Government Budget: 2012

Trends in Federal Spending as a Percentage of GDP

Military Spending to GDP: 10% from the 1950’s and Eisenhower’s warning of the MIC to around 5% today.

Social Security: 2.5% in 1962 to 4.8% in 2010.

Medicare: 0.7% in 1971 to 3.6% in 2010.

Medicaid: 0.3% in 1971 to 1.9% in 2010

Defense Spending as Percentage of GDP

Social Security as Percent of GDP

Medicare as Percent of GDP

Sources of Current Deficits

http://www.cbpp.org/cms/?fa=view&id=3849

Effect of the ARRA on Total Fed. Expenditures

Federal Expenditure Including Transfer Payments

Long-Run Debt Burden

Sources of Increases in Spending

http://www.cbo.gov/sites/default/files/cbofiles/attachments/06-05-Long-Term_Budget_Outlook_2.pdf

Projected Growth in Major Federal Spending Categories

http://www.cbo.gov/publication/43969

Social Security and Deficits

Myth: Social Security is a tremendous burden on our deficits.

Fact: Social Security is self-funded program, that by law, cannot pay out more that it has accumulated in its trust fund. It does not directly* add to the debt. For years it has generated a surplus.

Surpluses must be purchased by government.

Social Security is the largest owner of federal debt.

The trust fund is expected to be exhausted by 2033.

*http://crfb.org/blogs/general-revenue-social-security-trust-funds

Medicare and Deficits

Medicare runs a deficit. It was never supposed to be fully self-funding, except for part A (hospital insurance) and relied on general revenues.

The HI insurance trust fund has run surpluses for years and is currently drawing down on those surpluses.

The surpluses will be depleted in several years.

Parts B (medical insurance), Part C (Medicare Advantage), and Part D (prescription drug coverage) all draw from the general fund.

Increases in Medicare Spending

http://aspe.hhs.gov/health/reports/2013/medicarespendinggrowth/ib.cfm

Is Medicare a Spending Problem or a Healthcare Problem

The US spends more than twice as much per person on healthcare compared to the average developed nation.

Our doctors, hospitals, prescription drugs, and medical supplies are very costly.

If the US could manage to get its healthcare costs in line with other comparable countries, our deficit problems turn into surplus “problems”.

Per Capita Spending on Healthcare

http://pgpf.org/Chart-Archive/0006_health-care-oecd

Is Medicare a Spending Problem or a Healthcare Problem

http://www.cepr.net/index.php/blogs/beat-the-press/sorry-kids-thomas-friedman-is-not-very-good-at-economics

Medicare Costs are Slowing

http://www.whitehouse.gov/sites/default/files/docs/erp2013/ERP2013_Chapter_5.pdf

Main Taxation Categories: 2013

http://www.cbpp.org/cms/index.cfm?fa=view&id=3822

Sources of Federal Tax Revenue: 1945 - 2013

Tax Receipts as Percentage of GDP

http://www.heritage.org/federalbudget/current-tax-receipts#

Taxation

Marginal tax rate (MTR) are additional taxes owed as a percentage of additional income.

Average tax rate (ATR) are total taxes owed as a percentage of total income.

Three Main Types of Taxes Based on Tax Rates

Regressive: A regressive tax system is one where the rates decrease with an increase in income up to a certain point. Where the MTR < ATR

Proportional: Proportional taxation is where a fixed rate is applied regardless of the income amount. Where the MTR = ATR

Progressive: A progressive tax system is one where the rates increase with an increase in income up to a certain point. Where MTR > ATR

Fiscal Policy Effects on GDP, Price Level, and Employment

Changes in government spending (G) or taxation (T) can affect real GDP, employment, and the price level.

Expansionary Fiscal Policy – increases in G or decreases in T which will increase AD.

Price levels, GDP, and employment increase.

Contractionary Fiscal Policy – decreases in G or increases in T which will decrease AD.

Price levels, GDP, and employment decrease.

How Fiscal Policy Affects AD

Problem Type of Policy Actions by Congress and President

Result

Recession Expansionary Increase G and/or decrease T

Increases in real GDP, employment, and price level

Rising Inflation (due to overheating economy)

Contractionary Decrease G and/or Increase T

Decreases in GDP, employment, and price level.

ARRA: Spending in Billions

ARRA: Tax Cuts in Billions

Was the ARRA Effective?

“Estimated Impact of the ARRA on Employment and Economic Output from April 2011 Through June 2011”, CBO.

http://www.cbo.gov/sites/default/files/cbofiles/attachments/08-24-ARRA.pdf

Year Change in Real GDP

Change in UE Rate

Change in Employment (Millions)

Change in FTE Employment(Millions)

2009 0.9% to 1.9% -0.3% to -0.5% 0.5 to 0.9 0.7 to 1.3

2010 1.5% to 4.2% -0.7% to -1.8% 1.3 to 3.3 1.9 to 4.8

2011 0.8% to 2.3% -0.5% to -1.4% 0.9 to 2.7 1.2 to 3.7

2012 0.3% to 0.8% -0.2% to -0.6% 0.4 to 1.1 0.4 to 1.3

Why Was the Recession so Severe?

Why did a $825 billion dollar stimulus package leave the economy with real GDP far from its potential with unemployment rates over 9%?

Recession accompanied by financial crises tend to be more severe than recessions that do not involve a financial crises.

Reinhart and Rogoff gathered data on post-WWII countries that experienced a recession and a financial crisis, excluding the U.S.

Why Was the Recession so Severe?

EconomicVariable

Average Change Average Duration of Change (in years)

Number of Countries

UE Rate +7% points 4.8 14

Real GDP per capita

-9.3% 1.9 14

Real Stock Prices -55.9% 3.4 22

Real House Prices -35.5% 6 21

Real Gov’t Debt +86% 3 13

Why Was the Recession so Severe?

Comparing post-WWII recessions with the 2007-2009 Recession

Duration (in months)

Decline in Real GDP

Peak UE Rate

Average post –WWII recessions

10.4 -1.7% 7.6%

2007-2009 Recession

18 -4.1% 10.0%

Estimates of Various Multipliers

Economist Type of Multiplier Size

CBO Gov’t Expenditure 0.5 – 2.5

Iizetzki, Mendoza, and Vegh Gov’t Expenditure 0.8

Ramey Gov’t Expenditure 0.8 -1.5

Barro and Redlick Military Expenditure 0.4-0.5 (after one year) & 0.6-0.7 (after two years)

Cogan et al. Permanent Increase in Gov’t Expenditure

0.4

Romer et al. Permanent Increase in Gov’t Expenditure

1.6

CBO Tax 0.6-1.5 (lower & middle income) & 0.2-0.6 (higher income)

FRBSF Infrastructure 2 over 10 year time horizon.

ARRA Multipliers

http://www.cbo.gov/sites/default/files/cbofiles/attachments/05-25-Impact_of_ARRA.pdf

ARRA Multipliers: Moody’s

http://www.economy.com/mark-zandi/documents/Small%20Business_7_24_08.pdf

Federal Budget and Automatic Stabilizers

Mild recessions do not warrant significant (or any) fiscal policy action. Why?

Automatic stabilizers help mitigate the recession with no significant action from Congress or the President.

During a recession, federal deficits automatically increase. Gov’t spending automatically increases on unemployment benefits, aid to low-income, food stamps, etc. while tax receipts fall due to falling income.

Conversely, federal deficits decrease during times of expansion.

The Effect of Economic Fluctuations on the Budget Deficit

The federal government’s budget deficit was $207.8 billion in 1983 and $185.4 billion in 1984.

Someone comments, “The government must have acted during 1984 to raise taxes or cut spending or both”.

Do you agree?

The Effect of Economic Fluctuations on the Budget Deficit

A falling deficit does not mean that government musthave acted to raise taxes or cut spending.

The budget deficit will automatically decline when GDP increases, ceteris paribus. Why?

An increasing GDP typically means falling unemployment, which reduces government spending and increases in tax receipts.

In fact, GDP did increase from $3.5 trillion in 1983 to $3.9 trillion in 1984.

Limits to Fiscal Policy

It takes a lot of time (2 – 6 years) to feel the full effects of fiscal policy due to four timing lags.

1. Recognition lag – the time period required to recognize a problem.

2. Decision lag – the time needed to decide on a suitable course of action, including passing the legislation.

3. Implementation lag – the time needed to coordinate the changes in the budget for the government agencies involved and change tax policies.

4. The impact lag – the time need for the multiplier effect to work its way through the economy.

Limits to Fiscal Policy

Crowding out – a decline in private expenditures (C and I) as a result in increases of government deficit spending.

This eventually reduces the supply of loanable funds, driving up interest rates, and curbing household borrowing and investment.

Recall: Investment is new capital accumulation which is a prime determinant in labor productivity and therefore economic growth.

This is more of a limitation at full employment than at a depressed economy.