osp6_survey15

Prepared By Brock Williams

Chapter 15

Fiscal PolicyEconomists generally believe that permanent tax cuts will stimulate the economy and lead to higher

output, but disagree about why this happens. Some advocates for tax

cuts stress how they lead to increases in spending and

aggregate demand. Others suggest that the main effect comes

from changes in incentives and aggregate supply.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 15-2

Learning Objectives

1. Explain how fiscal policy works using aggregate demand and aggregate supply

2. Identify the main elements of spending and revenue for the U.S. federal government

3. Discuss the key episodes of active fiscal policy in the U.S. since World War II


● fiscal policyChanges in government taxes and spending that affect the level of GDP.

Fiscal Policy


15.1 THE ROLE OF FISCAL POLICY

Fiscal Policy and Aggregate Demand FIGURE 15.1Fiscal Policy in Action

Panel A shows that an increase in government spending shifts the aggregate demand curve from AD0 to AD1, restoring the economy to full employment. This is an example of expansionary policy.

Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD0 to AD1, restoring the economy to full employment. This is an example of contractionary policy.


Fiscal Policy and Aggregate Demand

● expansionary policiesGovernment policy actions that lead to increases in aggregate demand.

● contractionary policiesGovernment policy actions that lead to decreases in aggregate demand.

15.1 THE ROLE OF FISCAL POLICY (cont.)


The Fiscal Multiplier

● stabilization policiesPolicy actions taken to move the economy closer to full employment or potential output.

The Limits to Stabilization Policy

• As the government develops policies to stabilize the economy, it needs to take the multiplier into account.

• The total shift in aggregate demand will be larger than the initial shift. As we will see later in this chapter,

• U.S. policymakers have taken the multiplier into account as they have developed policies for the economy.



The Limits to Stabilization PolicyLAGS

FIGURE 15.2Possible Pitfalls in Stabilization Policy

Panel A shows an example of successful stabilization policy.

The solid line represents the behavior of GDP in the absence of policies. The dashed line shows the behavior of GDP when policies are in place. Successfully timed policies help smooth out economic fluctuations.

Panel B shows the consequences of ill-timed policies.

Again, the solid line shows GDP in the absence of policies and the dashed line shows GDP with policies in place. Notice how ill-timed policies make economic fluctuations greater.



The Limits to Stabilization Policy

LAGS

● inside lagsThe time it takes to formulate a policy.

● outside lagsThe time it takes for the policy to actually work.

FORECASTING UNCERTAINTIES

What makes the problem of lags even worse is that economists are not very accurate in forecasting what will happen in the economy.



Federal Spending

15.2 THE FEDERAL BUDGET

TABLE 15.1Federal Spending for Fiscal Year 2011


Federal Spending

● discretionary spendingThe spending programs that Congress authorizes on an annual basis.

● entitlement and mandatory spendingSpending that Congress has authorized by prior law, primarily providing support for individuals.

15.2 THE FEDERAL BUDGET (cont.)


Federal Spending

● Social SecurityA federal government program to provide retirement support and a host of other benefits.

● MedicareA federal government health program for the elderly.

● MedicaidA federal and state government health program for the poor.



• Today, Social Security, Medicare, and Medicaid constitute approximately 10 percent of GDP.

• Experts estimate that in 2075 spending on these programs will be approximately 22 percent of GDP.

How will our society cope with increased demands for these services?

Possible solutions:

• Leave the existing programs in place and just raise taxes to pay for them.

• The government should save and invest now to increase GDP in the future to reduce the burden on future generations.

• Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being.

• Reform the health-care system to encourage more competition to reduce health-care expenditures.

INCREASING LIFE EXPECTANCY AND AGING POPULATIONSSPUR COSTS OF ENTITLEMENT PROGRAMS

APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing

costs for their government programs?

A P P L I C A T I O N 1


Federal Revenues


TABLE 15.1Sources of Federal Government Revenue, Fiscal Year 2011


Federal Revenues

● supply-side economicsA school of thought that emphasizes the role that taxes play in the supply of output in the economy.

● Laffer curveA relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged.

SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE



• While the idea that cutting tax rates might actually increase tax revenue is often attributed to economist Arthur Laffer, in fact, it is actually a much older idea than that.

• Yu Juo, one of the twelve wise men who succeeded Confucius in ancient China, was asked what should be done in the case of a famine if the government had insufficient funds. He replied that the tax rate should be cut to 10 percent. Skeptical government bureaucrats did not have enough funds at a 20 percent rate, so how could they cut it to 10 percent?

• Yu Juo replied, “Cutting taxes and limiting your expenses allow people to raise their standard of living. Afterwards, you will no longer need to worry about famine and shortage.”

• Revenue estimators in Washington, D.C, do not share entirely in Yu Juo’s wisdom, but they do recognize that cutting tax rates will stimulate economic activity.

THE CONFUCIUS CURVE?APPLYING THE CONCEPTS #2: How are tax rates and tax

revenues related?



The Federal Deficit and Fiscal Policy

● budget deficitThe amount by which government spending exceeds revenues in a given year.

● budget surplusThe amount by which government revenues exceed government expenditures in a given year.



Automatic Stabilizers

● automatic stabilizersTaxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action.

The increased federal budget deficit works through three channels:

1 Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income.

2 Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much.

3 Because the corporation tax depends on corporate profits and profits fall in a recession, taxes on businesses also fall. Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession.



Are Deficits Bad?No – Automatic StabilizersYes – Crowding Out

P R I N C I P L E O F O P P O R T U N I T Y C O S TThe opportunity cost of something is what you sacrifice to get it.



The Depression Era

The Kennedy Administration

During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits. According to Brown, fiscal policy was expansionary only during two years of the Great Depression, 1931 and 1936.

Although modern fiscal policy was not deliberately used during the 1930s, the growth in military spending at the onset of World War II in 1941 increased total demand in the economy and helped pull the economy out of its long decade of poor performance. But to see fiscal policy in action, we need to turn to the 1960s. It was not until the presidency of John F. Kennedy during the early 1960s that modern fiscal policy came to be accepted.

15.3 FISCAL POLICY IN U.S. HISTORY


The Vietnam War Era

● permanent incomeAn estimate of a household’s long-run average level of income.

The Reagan Administration

The tax cuts enacted during 1981 at the beginning of the first term of President Ronald Reagan were significant. However, they were not proposed to increase aggregate demand. Instead, the tax cuts were justified on the basis of improving economic incentives and increasing the supply of output.

15.3 FISCAL POLICY IN U.S. HISTORY (cont.)


The Clinton, George W. Bush, and Obama Administrations

• At the beginning of his administration, President Bill Clinton proposed a “stimulus pachage” that would increase aggregate demand, but was defeated by Congress.

• Later, President Clinton, along with a Republican-controlled Congress, passed a major tax increase to balance the budget and brought the Federal budget into surplus.

• In 2001, President George W. Bush passed a 10-year tax cut plan in part to stimulate the economy.

• After September 11, 2001, President Bush and Congress authorized new spending to stimulate the economy which had entered a recession.

• This was followed by other expansionary fiscal policy

• In 2009, President Obama and Congress enacted the largest stimulus package in U.S. history.

• The stimulus was controversial in both size and composition.



A CLOSER LOOK AT THE 2009 STIMULUS PACKAGEAPPLYING THE CONCEPTS #3: Was the fiscal stimulus in

2009 successful?

• In 2009, President Obama signed into law the American Recovery and Reinvestment Act, the largest fiscal stimulus in United States history. Although the recovery of the economy from the 2007 recession was still sluggish, many economists—including those at the Congressional Budget Office—believe that the stimulus did have a significant impact on the economy.

• But not all economists share this belief. John B. Taylor, at Stanford University,. Based on his analysis, first examined whether the temporary tax cuts stimulated consumption spending. Consistent with much prior research on this topic, he found little evidence that the temporary tax cuts stimulated consumption; they were essentially saved. Taylor believes the stimulus was ineffective.



In late 1990’s, tax increases, limited government spending, and economic growth which increased revenues resulted in the U.S. experienced a surplusTax cuts and stimulus packages designed to stimulate the economy after the recessions of 2001 and 2008 resulted in U.S. deficits again.

▼ FIGURE 15.3Federal Taxes, Spending, and Deficits, 1996–2011


SOURCE: Congressional Budget Office, January 2012.


automatic stabilizers

budget deficit

budget surplus

contractionary policies

discretionary spending

entitlement and mandatory spending

expansionary policies

fiscal policy

inside lags

Laffer curve

Medicaid

Medicare

outside lags

permanent income

Social Security

stabilization policies

supply-side economics

K E Y T E R M S

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