6TOPICGovernment Budget and

Fiscal Policy

The National Budget

The national budget is the annual statement of the

government’s expenditures and tax revenues.

Fiscal policy is the use of the national budget to achieve

macroeconomic objectives, such as full employment,

sustained long-term economic growth, and price level

stability.

Gist: Using govt. purchases G and taxes T to control

unemployment or inflation

The National Budget

The government’s budget balance equals tax revenue

minus expenditure.

If tax revenues exceed expenditures, the government has

a budget surplus [T>G].

If expenditures exceed tax revenues, the government has

a budget deficit [G>T].

If tax revenues equal expenditures, the government has a

balanced budget [T=G].

The Federal Budget - USA

Government Budget Balance - Bangladesh

This Figure shows receipts as a percentage of GDP.

Receipts

Federal Receipts - USA

Federal Receipts - USA

Social Security tax

The tax levied on both employers and employees used to

fund the Social Security program. The Social Security tax

pays for the retirement and disability benefits received by

millions of Americans each year.

Government receipts - Bangladesh

Source: www.mof.gov.bd

The Federal Outlays - USA

This Figure shows outlays as a percentage of GDP.

Outlays

Government Outlays - Bangladesh

Source: www.mof.gov.bd

Source: The Daily Star, June 14, 2019

The National Budget

Cyclical Deficits and Structural Deficits

Suppose the budget is currently balanced, and then Real GDP in

the economy drops.

As Real GDP drops, the tax base of the economy falls, and, if tax rates

are held constant, tax revenues will fall.

Another result of the decline in Real GDP is that transfer payments (e.g.,

unemployment compensation) will rise.

Thus, government expenditures will rise as tax revenues fall.

As a result, a balanced budget turns into a budget deficit—a result of the

downturn in economic activity, not from current spending and taxing

decisions by the government.

The National Budget

Cyclical Deficits and Structural Deficits

Economists use the term cyclical deficit to describe

budget deficit that is a result of a downturn in economic

activity.

On the other hand deficit that would exist if the economy

were operating at full employment—is called the structural

deficit.

The National Budget

This Figure illustrates a

cyclical deficit and a

cyclical surplus.

In part (a), potential GDP

is $14 trillion.

If real GDP is $13 trillion,

the budget is in deficit and

it is a cyclical deficit.

If real GDP is $15 trillion,

the budget is in surplus

and it is a cyclical surplus.

The National Budget

In part (b), if real GDP and potential GDP are $13 trillion, the budget is a deficit and the deficit is a structural deficit.

If real GDP and potential GDP are $14 trillion, the budget is balanced.

If real GDP and potential GDP are $15 trillion, the budget is a surplus and the surplus is a structural surplus.

Budget Balance and Debt

Government debt or Public

debt is the total amount that

the government has borrowed.

It is the sum of past deficits

minus past surpluses.

This Figure shows the federal

government’s (in the U.S.)

gross debt ...

and net debt.

The National Budget

Government enters the loanable funds market when it has

a budget surplus or deficit.

A government budget surplus increases the supply of

funds.

A government budget deficit increases the demand for

funds.

Budget Deficit and the Crowding-Out Effect

This Figure illustrates the

effect of a government

budget deficit.

A government budget

deficit increases the

demand for funds.

The real interest rate rises.

Private saving increases.

Investment decreases—is

crowded out.

Budget Deficit and the Crowding-Out Effect

This Figure illustrates the

Ricardo-Barro effect.

A budget deficit increases the

demand for funds.

Rational taxpayers, in

anticipation of higher future

tax rates increase saving,

which increases the supply of

funds.

Increased private saving

finances the deficit.

Crowding-out is avoided.

Budget Deficit and the Crowding-Out Effect

Fiscal Policy Multipliers

Before we discuss fiscal policy and it’s effect on real

GDP and price level, we need to make the following

assumptions:

Economy is not self regulating when it is in a recessionary

gap (similar to Keynesian assumption).

Price is not constant in the short run, i.e., SRAS is upward

sloping (similar to Classical view).

So, we are somewhere in between the Classical and the

Keynesian model.

Fiscal Policy Multipliers

Automatic fiscal policy is a change in fiscal policy triggered

automatically by the state of the economy. To illustrate, suppose Real

GDP in the economy turns down, causing more people to become

unemployed and, as a result, automatically receive unemployment

benefits. These added unemployment benefits automatically boost

government spending.

Discretionary fiscal policy is a policy action that is initiated by an act

of the Government, taken deliberately.

To enable us to focus on the principles of fiscal policy multipliers, we

first study discretionary fiscal policy in a model economy that has only

“lump-sum” taxes.

Lump-sum taxes are taxes that do not vary with real GDP; actual

examples would be a ‘head tax’ or property taxes.

Fiscal Policy Multipliers

The Government Purchases Multiplier

The government purchases multiplier is the

magnification effect of a change in government purchases

of goods and services on equilibrium aggregate

expenditure and real GDP.

A multiplier exists because government purchases are a

component of aggregate expenditure; an increase in

government purchases increases aggregate income,

which induces additional consumption expenditure.

Fiscal Policy Multipliers

This Figure illustrates

the government

purchases multiplier in

the aggregate

expenditure diagram.

The government

purchases multiplier is

1/(1 – MPC) where MPC is

the marginal propensity to

consume (absent induced

taxes and imports).

Fiscal Policy Multipliers

The Lump-Sum Tax Multiplier

The lump-sum tax multiplier is the magnification effect a

change in lump-sum taxes has on equilibrium aggregate

expenditure and real GDP.

An increase in lump-sum taxes decreases disposable

income, which decreases consumption expenditure and

decreases aggregate expenditure and real GDP.

Fiscal Policy Multipliers

The amount by which a tax increase lowers consumption

expenditure is determined by the MPC.

A $1 tax increase lowers consumption expenditure by $1

MPC, and this amount gets multiplied by the standard

autonomous expenditures multiplier.

The lump-sum tax multiplier is therefore -[MPC/(1 –

MPC)].

It is negative because an increase in lump-sum taxes

decreases equilibrium expenditure.

Fiscal Policy Multipliers

This Figure illustrates

the effect of an increase

in lump-sum taxes.

The lump-sum transfer

payments multiplier and

the lump-sum tax multiplier

are the same except for

their signs—the transfer

payments multiplier is

positive.

Fiscal Policy Multipliers

Fiscal Policy and

Aggregate Demand

This Figure illustrates

the effects of fiscal

policy on aggregate

demand.

An increase in

government

purchases shifts the

AE curve upward

and shifts the AD

curve rightward.

Fiscal Policy Multipliers

The magnitude of the shift in the AD curve equals the government purchases multiplier times the increase in government purchases.

When lump-sum taxes decrease, the rightward shift in the AD curve equals the lump-sum tax multiplier times the reduction in taxes.

Fiscal Policy

Expansionary fiscal policy, an increase in government

expenditures (𝐺) or a decrease in taxes (𝑇), shifts the AD

curve to the right. The target of an expansionary fiscal

policy is to increase production and reduce unemployment.

The underlying assumption is that the economy is in a

recessionary gap.

Contractionary fiscal policy, a decrease in government

expenditures (𝐺) or an increase in taxes (𝑇), shifts the AD

curve to the left. The target of an contractionary fiscal policy

is to decrease production and reduce inflation. The

underlying assumption is that the economy is in an

inflationary gap.

Fiscal Policy

Graphical Illustration of

Fiscal Stimulus

This Figure shows how fiscal policy

is supposed to work to close a

recessionary gap.

An increase in government

expenditure or a tax cut increases

aggregate expenditure.

The multiplier process increases

aggregate demand.

If no supply side effect is present,

then ∆𝑇 would need be larger than

∆𝐺 to get GDP to potential GDP.

Limitations of Fiscal Policy

Because the short-run fiscal policy multipliers are not

zero, fiscal policy can be used to help stabilize the

economy, and frequently is in countries with

parliamentary systems of government [or other systems

that allow the executive to control the budget].

But in practice, fiscal policy is always hard to use, and in

the US usually not feasible, because:

The legislative process is too slow to permit fiscal policy actions

to be implemented when they are needed.

Potential GDP is very hard to estimate, so the wrong fiscal

stimulus or restraint may be enacted.

Limitations of Fiscal Policy

Fiscal Policy May Destabilize the

Economy

In this scenario, the 𝑆𝑅𝐴𝑆 curve is

shifting rightward (healing the

economy of its recessionary gap),

but this information is unknown to

policy makers. Policy makers

implement expansionary fiscal

policy, and the 𝐴𝐷 curve ends up

intersecting 𝑆𝑅𝐴𝑆2 at point 2

instead of intersecting 𝑆𝑅𝐴𝑆1 at

point 1′. Policy makers thereby

move the economy into an

inflationary gap, thus destabilizing

the economy.

Supply-Side Effects of Fiscal Policy

Fiscal Policy and Aggregate Supply

Production depends on the quantity of labor, which in turn

is influenced by the income tax.

Figure on the next slide illustrates the effect of the income

tax in the labor market.

Supply-Side Effects of Fiscal Policy

The income tax

decreases the

aggregate supply of

labor because it

decreases the after-

tax wage rate.

Because the income tax

decreases the aggregate

supply of labor, it raises

the equilibrium wage rate,

decreases employment,

and decreases aggregate

supply.

Supply-Side Effects of Fiscal Policy

This supply-side effect of the income tax means that a cut in the income tax rate may increase aggregate supply.

Supply Side Effects of Fiscal Policy

This Figure illustrates

two views about the

effects of a tax cut on

real GDP and the

price level (assuming

the economy is in a

recessionary gap).

A tax cut increases

aggregate demand

and the AD curve

shifts rightward.

Supply-Side Effects of Fiscal Policy

Most economists

believe that a tax

cut has a small

effect on aggregate

supply [SAS0 to

SAS1].

So GDP increases

and the price level

rises.

Supply-Side Effects of Fiscal Policy

Supply-side

economists think that

a tax cut may

increase aggregate

supply by a large

amount [SAS0 to

SAS2] so that GDP

can increase and the

price level does not

change much (or

maybe even fall).

Tax Rates and Tax Revenues

Laffer Curve

The curve, named after

Arthur Laffer, that shows the

relationship between tax

rates and tax revenues.

According to the Laffer

curve, as tax rates rise from

zero, tax revenues rise,

reach a maximum at some

point, and then fall with

further increases in tax rates.

Tax Rates and Tax Revenues

Laffer Curve

Tax revenues = Tax base × Average Tax rate

As tax rate increases:

Direct effect: Upward pressure on tax revenues

Indirect effect: Downward pressure on tax base →Downward pressure on tax revenues

Tax base is a direct function of Real GDP.

An increase in tax rate puts downward pressure on tax base

because: increased tax rate → both demand and supply curve

(according to supply-side economists) shift leftward → Real GDP

falls → Tax base falls.

Tax Rates and Tax Revenues

Laffer Curve

Between point A and

point B, the direct effect

dominates, so, tax

revenues increase.

Between point B and

point C, the indirect

effect dominates.

Rationale: The greater

the proportion of one’s

income is taken away

in taxes, the lesser the

incentive for working.

At point B, tax revenues

are maximized.

Tax rates in Bangladesh

According to a National Board of Revenue (NBR),

Bangladesh circular, in 2019-20:

Tax free Income

For men less than 65 years of age: Tk. 20,833/month

For women and people over 65 years of age: Tk. 25,000/month

For people with disability: Tk. 33,333/month

Tax rates in Bangladesh

Tax rates

Total Income (Yearly) Tax rate

First 2,50,000 Tk. 0%

Next 4,00,000 Tk. 10%

Next 5,00,000 Tk. 15%

Next 6,00,000 Tk. 20%

Next 30,00,000 Tk. 25%

Any remaining income 30%