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Evolution of Fiscal Policy MakingPrior to the Great Depression, public policy was shaped by the views of classical economists

Believed that free markets were the best way to achieve national economic prosperity

Economists believed that natural market forces, such as changes in prices, wages, and interest rates, would correct the problems of inflation and unemployment no need for government intervention in the economy

Government deficit considered immoral. Thought active fiscal policy would do harm, not good (Fed Gov’t small player anyway – 3% vs 20% of GDP today).

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Great Depression and World War II

Long depression of 1930’s made people question classical school of thought (economy will correct itself)

Unemployment at 25%

1936 - Keynes, Cambridge University, “General Theory of Employment, Interest and Money”

Keynesian theory and policy were developed to address the problem of unemployment arising from the Great Depression

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Keynes’s main quarrel with the classical economists was that prices and wages did not appear flexible enough to ensure the full employment of resources, e.g, they were sticky natural forces would not return the economy to full employment in a timely period .(Recall our model, wages and prices must adjust to move back to potential output)

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Great Depression and World War II

Keynes also believed business expectations might at times become so bleak that even very low interest rates would not spur firms to invest all that consumers might save.

Much learned about economy through studying Great Depression

The Great Depression continues to influence economic thought and policy solutions

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Great Depression and World War II

Three developments following the Great Depression bolstered the use of discretionary fiscal policy in the United States

The influence of Keynes’s General Theory in which he argued that natural forces would not necessarily close a contractionary gap government would have to increase aggregate demand so as to boost output and employment

The demands of World War II greatly increased production and in the process eliminated cyclical unemployment during the war years

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Great Depression and World War II

The third development, largely a consequence of the first two, was the passage of the Employment Act of 1946, which gave the federal government responsibility for promoting full employment and price stability (prior to this time, only fiscal policy was balanced budget)The combined impact of these factors led policy makers grew more receptive to the idea that fiscal policy could improve economic stability.Additionally, the objective of fiscal policy was no longer to balance the budget but to promote full employment with price stability even if deficits occurred in the process

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From the Golden Age to Stagflation

John F. Kennedy was the first president to propose a federal budget deficit to stimulate an economy by proposing a tax cut for the purpose of stimulating business investment, consumption, and employment

Discretionary fiscal policy is a type of demand-management policy because the objective is to increase or decrease aggregate demand to smooth fluctuations

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From the Golden Age to Stagflation

However, the 1970s were different when the problem was stagflation the double trouble of higher inflation and higher unemployment resulting from a decrease in aggregate supply

Demand-management policies were ill suited to solve these problems because an increase in aggregate demand would worsen inflation, whereas a decrease in aggregate demand would worsen unemployment

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Problems with Fiscal PolicyOther concerns also caused economists and policy makers to question the effectiveness of discretionary fiscal policy

The difficulty of estimating the natural rate of unemploymentThe time lags involved in implementing fiscal policyThe distinction between current and permanent incomePossible feedback effects of fiscal policy on aggregate supply

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Natural Rate of Unemployment

The unemployment rate that occurs when the economy is producing its potential GDP is called the natural rate of unemployment

Before adopting discretionary policies, public officials must correctly estimate this natural rate

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Lags in Fiscal PolicyThe time required approving and implementing fiscal legislation may hamper its effectiveness and weaken discretionary fiscal policy and may in fact do more harm than good

Since a recession is not usually identified as such until at least six months after it begins, and since the recessions since 1949 lasted an average of 11 months, this leaves a narrow window in which to execute discretionary fiscal policy

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Permanent IncomeThe original belief was that given the marginal propensity to consume, a relationship that is among the most stable in macroeconomics, tax changes could increase or decrease disposable income to bring about any desired change in consumption

A more recent view is that people base their consumption decisions not merely on changes in their current income but on changes in their permanent income

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Permanent Income

Permanent income is the income a person expects to receive on average over the long run

Thus, changes in taxes that are regarded as temporary will not stimulate consumption and may render fiscal policy ineffective

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Feedback Effects

Fiscal policy may unintentionally affect aggregate supply

For example, suppose the government increases unemployment benefits and finances these transfer payments with higher taxes on current workers.

If the marginal propensity to consume is the same for both groups, the reduction in spending by those whose taxes increase should just offset the increase in spending by transfer recipients

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Feedback EffectsThus, with a fiscal policy that focuses on aggregate demand, there should be no change in aggregate demand or on equilibrium real GDP

But what of possible effects of these changes on the labor supply?

The unemployed, who benefit from increased transfers, now have less incentive to find work

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Feedback Effects

Conversely, workers who find their after-tax wage reduced by the higher tax rates may be less willing to work

In short, the supply of labor could decrease as a result of offsetting changes in taxes and transfers with the result that aggregate supply would decline economy’s potential GDP would decline

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Budget Deficits of the 1980s and 1990s

The Reagan tax rate cut reflected a philosophy that reductions in tax rates would make people more willing to work and to invest because they could keep more of what they earned

Lower taxes, would increase the supply of labor and the supply of other resources thereby increasing aggregate supply and the economy’s potential GDP

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Supply Side EconomicsThis supply-side theory held that enough additional real GDP would be generated by the tax cuts that total tax revenue would actually increase

What actually happened?

Taking 1981 to 1988 as the time frame, we can examine the effects of the 1981 federal income tax rate cut.

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Supply Side Economics

After the tax cut was approved but before it took effect, a recession hit the economy and the unemployment rate increasedBetween 1981 and 1988 employment climbed by 15 million and real GDP per capita increased by about 2.5% per yearThe stimulus from the tax rate cut helped sustain a continued expansion during the 1980s, the longest peacetime expansion to that point in history

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Supply Side Economics

Despite the growth in employment, government revenues did not expand to offset the combination of tax cuts and increased government spendingBetween 1981 and 1988, federal outlays grew an average of 7.1% while federal revenues averaged a 6.3% increase the deficits accumulated into a huge national debt which doubled relative to GDP from 33% in 1981 to 64% in 1992

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Political Business Cycles

William Nordhaus developed a theory of political business cycles, arguing that incumbent presidents use expansionary policies to stimulate the economy, often only temporarily, during an election yearThat is, they try to increase their chances of reelection by pursuing policies that stimulate real GDP and reduce unemployment

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Political Business Cycles

The evidence to support the theory of political business cycles is not entirely convincing

One problem is that the theory limits presidential motives to reelection, when in fact presidents may have other objectives

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Political Business Cycles

An alternative to this theory, and one that is supported by some evidence, is that Democrats care relatively more about unemployment and relatively less about inflation than do Republicans

Democrats tend to pursue expansionary policies while Republicans tend to pursue contractionary policies

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Balancing the Budget

The combination of increased taxes imposed by the Clinton administration and a vigorous recovery fueled by growing consumer spending, rising business optimism, and the strongest stock market in history led to record budget surplusesHowever, by early 2001, U.S. economic growth was slowing, so that President George W. Bush pushed through across the board tax cuts

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Balancing the Budget

The terrorist attack on September 11, 2001 further depressed consumer confidence with the result that taxpayers spent only about one-fifth of the tax rebate checks

Thus, additional stimulus programs were put in place Leading to current recovery