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Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 13

Fiscal Policy


13-2

Introduction

Government expenditures on health care services have grown significantly since federal and state government began covering payments for various types of health-related expenses in the mid-1960s.

Today, government health care expenditures account for more than 30% of all federal government spending and as much as 35% of state government spending.

Do on-going increases in government health care spending generate dollar-for-dollar increases in total planned expenditures in the U.S.? Do higher government health care expenditures displace a portion of private health care spending?


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Learning Objectives

• Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policy

• Discuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions

• Explain why the Ricardian equivalence theorem calls into question the usefulness of tax changes


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Learning Objectives (cont'd)

• List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal “fine tuning”

• Describe how certain aspects of fiscal policy function as automatic stabilizers for the country


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Chapter Outline

• Discretionary Fiscal Policy• Possible Offsets to Fiscal Policy• Discretionary Fiscal Policy in Practice:

Coping with Time Lags • Automatic Stabilizers• What Do We Really Know About Fiscal

Policy?


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Did You Know That...

• When President Woodrow Wilson signed into law the U.S. federal income tax on October 1913, only about 1% of the U.S. population owed any income taxes.

• The Tax Foundation estimates that for $1 that households earning less than $24,000 per year pay in taxes, they get back transfers and services valued at $8.21.

• Every year, the government collects nearly $3 trillion in tax payments. The government spends $0.5 trillion more than this by borrowing the additional funds.

• In this chapter, you will learn about how variations in taxes and government spending affect real GDP and the price level.


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Discretionary Fiscal Policy

• Fiscal Policy

– The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals, such as:

• High employment (low unemployment)

• Price stability

• Economic growth

• Improvement of international payments balance


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Discretionary Fiscal Policy (cont'd)

• An increase in government spending will stimulate economic activity

• Changes in government spending– Military spending– Education spending– Budgets for government agencies


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Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a)

If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand


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Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b)

If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand


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• Questions

– Would the increase in government spending equal the size of the gap?

– What impact would expansionary fiscal policy have on the price level?


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Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a)

• In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibrium• Contractionary fiscal policy can

move aggregate demand to AD2 via a tax increase• A new equilibrium is at E2 at a

lower price level• Real GDP is now consistent

with LRAS


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Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b)

• In panel (b) with a recessionary gap (in this case $500 billion) taxes are cut

• AD1 moves to AD2

• The economy moves from E1to E2, and real GDP is now at $12 trillion per year

• We are at the long-run equilibrium level


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• Change in taxes

– A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports.


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• Question

– What would be the long-run impact of a tax cut on real GDP if the economy is at full-employment equilibrium?


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International Policy Example: Struggling to Boost Government Spending in Peru

• The president of Peru sought $1 billion in new expenditures on roads, drinking water facilities, and improvements to schools/hospitals. Five months later, only $160 million had been spent.

• Peru’s system requires national government spending to be coordinated with regional governments, so the president had to coordinate with 23 new governors.

• Why did the $160 million in government spending after five months likely shift Peru’s aggregate demand curve rightward by more than that amount?


13-17

Possible Offsets to Fiscal Policy

• Fiscal policy does not operate in a vacuum and important questions must be answered.

– How are expenditures financed and by whom?

– If taxes are increased what does government do with the taxes?

– What will happen if individuals worry about increases in future taxes?


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Possible Offsets to Fiscal Policy (cont'd)

• Crowding-Out Effect

– The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.


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Figure 13-3 The Crowding-Out Effect, Step by Step


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Figure 13-4 The Crowding-Out Effect

Expansionary policy causing deficit spending initially shifts from AD1 to AD2

Due to crowding out, AD shifts inward to AD3

Equilibrium GDPbelow full-employment GDP—recessionary gap


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• Planning for the future: the Ricardian equivalence theorem

– Ricardian Equivalence Theorem• The proposition that an increase in the government

budget deficit has no effect on aggregate demand


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• Planning for the future: The Ricardian equivalence theorem

– The reason for the offset• People anticipate that a larger deficit today will mean

higher taxes in the future and adjust their spending accordingly.


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• Direct Expenditure Offsets

– Actions on the part of the private sector in spending income that offset government fiscal policy actions

– Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset.


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• The supply-side effects of changes in taxes

– Expansionary fiscal policy could involve reducing marginal tax rates. • Advocates argue this increases productivity since

individuals will work harder and longer, save more, and invest more.

• The increased productivity will lead to more economic growth.


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• Supply-Side Economics

– The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward


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• Question

– Would a tax increase cause you to work more or less?


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Figure 13-5 Laffer Curve

Tax rates andtax revenuesrise together

Tax revenues are at a maximum

Tax rates and tax revenues fall together


13-28

Policy Example: A Laffer Curve in the Mid-2000s?

• In 2003 Congress reduced the top tax rate on corporate dividends and the tax rate on capital gains along with cutting personal income tax rates slightly.

• Many critics predicted that the federal government’s tax revenues would plummet after these rates were cut.


13-29

Policy Example: A Laffer Curve in the Mid-2000s? (cont'd)

• By the middle of 2008, after five years of higher real GDP growth, total federal income tax receipts from corporations and individuals had increased by nearly 50%.

• Why do you suppose it is difficult to determine exactly which factors are most responsible for the increase?


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Discretionary Fiscal Policy in Practice: Coping with Time Lags

• Question

– Is fiscal policy as precise as it appears?


13-31

Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)

• Time lags

– Recognition Time Lag• The time required to gather information about the

current state of the economy


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• Time lags

– Action Time Lag

• The time required between recognizing an economic problem and putting policy into effect

– Particularly long for fiscal policy which requires congressional approval


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• Time lags

– Effect Time Lag• The time it takes for a fiscal policy to affect the

economy


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• Fiscal policy time lags are:

– Long – a policy designed to correct a recession may not produce results until the economy is experiencing inflation.

– Variable in length – they can be from 1-3 years, and the timing of the desired effect cannot be predicted.

• Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.


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Automatic Stabilizers

• Automatic or Built-In Stabilizers

– Changes in government spending and taxation that occur automatically without deliberate action of Congress• The tax system

• Unemployment compensation

• Welfare spending


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Automatic Stabilizers (cont’d)

• The Tax System– Incomes and profits fall when business activity

slows down, and the government’s tax revenues drop as well.

– Some economists consider this an automatic tax cut, which therefore stimulates aggregate demand.


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• Unemployment Compensation and Income Transfer Payments– Unemployment compensation reduces changes in

people’s disposable income. Their disposable income remains positive, although at a lower level.

– In a recession, more people are eligible for income transfer payments and do not experience as dramatic a drop in disposable income.


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• Stabilizing Impact– The key impact of these systems is the ability to

mitigate changes in disposable income, consumption, and the equilibrium level of GDP.

– If disposable income is prevented from falling as much as it otherwise would in a recession, the downturn will be moderated.


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Figure 13-6 Automatic Stabilizers

The automatic changes tend to drive the economy back toward its full-employment output level


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What Do We Really Know About Fiscal Policy?

• Fiscal policy during normal times

– Congress ends up doing too little too late to help in a minor recession.

– Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty.


13-41

What Do We Really Know About Fiscal Policy? (cont'd)

• Fiscal policy during abnormal times

– Fiscal policy can be effective • The Great Depression—fiscal policy may be able to

stimulate aggregate demand.

• Wartime—during World War II real GDP increased dramatically.


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What Do We Really Know About Fiscal Policy? (cont'd)

• The “soothing” effect of Keynesian fiscal policy

– Should we encounter a severe downturn, fiscal policy is available.

• Knowing this may reassure consumers and investors.

– Stable expectations encourage a smoothing of investment spending.


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Issues and Applications: Does Government Spending Crowd Out Private Health Care Expenditures?

• Since the mid-1960s, the federal government has directed an increasing share of tax dollars to expenditures on health care services for U.S. residents.

• The government’s spending on Medicare is nearly $500 billion per year, or about 20% of total—combined public and private—health care spending.

• Much of the recent growth in federal health care spending, however, has occurred through expansions of Medicaid and the State Children’s Health Insurance Program.


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Issues and Applications: Does Government Spending Crowd Out Private Health Care Expenditures? (cont'd)

• Congress typically says that expanding health care spending will provide health care for U.S. residents who otherwise would be privately uninsured and unable to pay for services from their own resources.

• There is evidence that government health care expenditures crowd out a significant share of health care spending that otherwise would be undertaken from private funds.


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Issues and Applications: Does Government Spending Crowd Out Private Health Care Expenditures? (cont'd)

• Studies conducted by Gruber and Simon estimate that new government coverage of health care spending reduced private provisions for health care expenditures by about 60%.

• Based on Gruber and Simon’s estimate, has the expansion of government health care spending succeeded in covering some people who otherwise might not have had coverage of health care expenses?


13-46

Summary Discussion of Learning Objectives

• The effects of discretionary fiscal policy using traditional Keynesian analysis

– Increases in government spending and decreases in taxes increase aggregate demand.

– Decreases in government spending and increases in taxes decrease aggregate demand.


13-47

Summary Discussion of Learning Objectives (cont'd)

• How indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions– Deficits increase interest rates.

– Some government spending replaces private spending.

• If the Ricardian equivalence theorem is valid, a tax cut has no effect on total planned expenditures and aggregate demand.


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Summary Discussion of Learning Objectives (cont'd)

• Fiscal policy time lags and the effectiveness of fiscal “fine tuning”– The time lags for fiscal policy are the recognition

time lag, action time lag, and the effect time lag.

– The time lags are long and variable.

• Automatic stabilizers are changes in tax payments, unemployment compensation, and welfare payments that automatically change with the level of economic activity.


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Figure C-1 The Impact of Higher Government Spending on Aggregate Demand


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Figure C-2 The Impact of Higher Taxes on Aggregate Demand

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