Fiscal policy topics 1 Sources of Federal revenue and expenditures Expansionary and contractionary...

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Fiscal policy topics Sources of Federal revenue and expenditures Expansionary and contractionary fiscal policy Spending multiplier Tax multiplier Automatic stabilizers Budget deficits and the national debt Long-term issues

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Federal revenue

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Federal revenue Three largest sources:

Individual income tax Social security tax Corporate income tax

Top three combined account for 89% of federal revenue

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Income tax Individual income tax is a progressive tax:

Individuals with larger incomes pay a larger percent of income in tax

Individuals with smaller incomes pay a smaller percent of income in tax

Some individuals pay no tax, some have a negative tax rate

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Income tax Income tax due is based on taxable

income. To arrive at taxable income, start with

your income and subtract deductions and exemptions.

One exemption is allowed for each person

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Income tax Example: Sheila is a single person with

an income of $50,000

Gross Income

$50,000

Standard deduction

-$6,200

Exemption -$3,900

Taxable income

$42,900

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Income tax How much federal income tax does

Sheila pay?

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Income tax brackets

Income Thresholds

Taxable

income

Marginal tax rate

Tax

Up to $9,075 $9,075 10% $907$9,076-$36,900

$27,825 15% $4,174

$36,901-$89,000 $6,000 25% $1,500

$42,900

$6,581

Sheila pays $6,581 in federal income tax

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Income tax Sheila’s average tax rate : $6,581 / $50,000 =

13.2% Sheila’s marginal tax rate is 25%

She would pay 25% tax on any additional income

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Federal expenditures

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Federal expenditures Four largest sources:

Medicare and Medicaid Social security National defense Income security

Top four account for 83% of federal expenditures. Medicare and Medicaid is the fastest growing component.

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Expansionary and contractionary fiscal policy What is the correct fiscal policy for

A recession? An inflationary period?

Recession: Increase government spending, and/or Cut taxes

Inflation: Cut government spending, and/or Increase taxes

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Recessionary gap

Real GDP

Price level

SRAS0

Y*

LRAS0

AD1

Y1

P1 A

Recessionary Gap

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Expansionary fiscal policy

Real GDP

Price level

SRAS0

Y*

LRAS0

AD1

Y1

P1 A

AD2

BP2

Increased government spending can pump up aggregate demand

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Suppose the output gap is $200 billion. How much would government spending need to increase to close the gap?

Use the spending multiplier:

∆Y = * ∆G

Assume MPC = 0.7

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$200 billion = * ∆G


∆G = $200 billion / 3.3 = $60.6 billion

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Government spending would need to rise by $60.6 billion to cause output to increase by $200 billion.

Consumption spending accounts for most of the increase in output.

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Linkages – expansionary fiscal policy

Increased government spending or lower taxes

Aggregate demand increases

Output rises

Unemployment rate falls

Spending multiplier

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What if the government cut taxes instead of increasing government spending?

How much would tax revenue need to be reduced?

We must use the tax multiplier to find out.

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Tax multiplier

∆Y = * ∆T

T = tax revenue

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Tax multiplierExample: We want output to rise by $200 billion. How much would tax revenue need to decline?

$200 billion = * ∆T

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Tax multiplierExample: We want output to rise by $200 billion. How much would tax revenue need to decline?

$200 billion = -2.33 * ∆T

∆T = $200 billion / -2.33 = -$85.8 billion

Taxes would need to be cut by $85.5 billion.

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Government spending and tax revenue

We have found that to increase output by $200 billion we could

Increase government spending by $60.6 billion, or

Cut taxes by $85.5 billion.

Why aren’t these figures the same?

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Y = C + I + G + NX

If government spending rises by $1, how much does output rise immediately?

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Y = C + I + G + NX

If government spending rises by $1, output rises by $1. Government spending is a direct component of aggregate demand.

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Y = C + I + G + NXC = a + b(Yd)

If taxes are cut by $1, how much does output rise?

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Government spending and tax revenueY = C + I + G + NXC = a + b(Yd)

If taxes are cut by $1, output rises by $1*MPC. Taxes affect aggregate demand indirectly.

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Contractionary fiscal policySuppose the economy is suffering from high inflation. Output is higher than potential output and unemployment is very low.

Assume the inflationary gap equals $80 billion in output.

The government can reduce the output gap by cutting government spending (or increasing taxes).

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Inflationary gap

Real GDP

Price level

SRAS0

Y*

LRAS0

AD1

Y1

P1 A

Inflationary Gap

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Contractionary monetary policy

Real GDP

Price level

SRAS0

Y*

LRAS0

AD1

Y1

P1 A

Inflationary Gap

AD2

P2 B

Cuts in government spending can reduce aggregate demand

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Expansionary monetary policy

The inflationary gap is $80 billion. How much would investment spending need to decrease to close the gap?

∆Y = * ∆G

Assume MPC = 0.7

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Contractionary fiscal policy



∆G = $80 billion / 3.3 = $24.2 billion

Government spending would need to be cut by $24.2 billion to cause output to decline by $80 billion.

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Contractionary fiscal policyQuestion: how much of a tax increase would be needed to reduce output by $80 billion? Assume the MPC = 0.7

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Contractionary fiscal policyQuestion: how much of a tax increase would be needed to reduce output by $80 billion? Assume the MPC = 0.7

Answer:

-$80 billion = * ∆T

∆T = -$80 billion / -2.33 = $34.3 billion

Taxes would need to increase by $34.3 billion

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Linkages – contractionary fiscal policy Cuts in

government spending or

increased taxes

Aggregate demand

decreasesOutput

decreasesPrice level declines

Spending multiplier

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Balanced budget multiplierSuppose increased government spending is balanced by an equal increase in tax revenue. What is the effect on output?

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Balanced budget multiplier

∆Y = * ∆G = 3.3 * $10 billion = +$33 billion

∆Y = * ∆T = -2.3 * $10 billion = -$23 billion

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Balanced budget multiplier

∆Y = * ∆G = 3.3 * $10 billion = +$33 billion

∆Y = * ∆T = -2.3 * $10 billion = -$23 billion

+$33 billion -$23 billion = +$10 billion net gain

The balanced budget multiplier equals one.

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Question 56Suppose I pay $15,000 income tax on a taxable income of $100,000. Therefore, my marginal tax rate is 15%.A) TrueB) False

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Question 57To increase output by $50 billion, how much would taxes have to be cut? Assume the MPC = 0.8Cut in taxes: $____ billion (leave out the negative sign)

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Question 58To increase output by $50 billion, how much would government spending need to increase? Assume the MPC = 0.8Increase in government spending: $____ billion

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Fiscal policy issues

Conclusion: in the short-run, fiscal policy can shift aggregate demand in the desired direction.

Three problems arise that cause complications.

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1) Crowding out

2) Timing and policy lag

3) Negative supply shocks

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Crowding out - occurs when increased government spending results in less private spending

Two cases: how is the government spending paid for?

1) Higher taxes or2) More borrowing?

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A) Government spending funded by taxes

If government spends $100 million on new highways and increases taxes by $100 million, does net spending increase?

It depends – would the private sector have spent the $100 million?

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If the private sector would have spent most (90%) of the $100 million, then the impact of $100 million in government spending would be very small.

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But what if confidence is low, and the private sector would NOT have spent most of the $100 million.

In this case, the impact of $100 million in government spending would be much larger.

Expansionary fiscal policy is effective when the private sector is afraid to spend money.

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B) Government spending funded by borrowing

If government spends $100 million on new highways paid for by borrowing, does net spending increase?

The public purchases more ($100 million) government bonds and fewer private bonds.

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If the private bonds would have funded new factories, then investment spending falls.

Also, interest rates rise when the government sells bonds, causing additional decline in investment spending.

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What if the private sector would not have invested the money in new plant and equipment? That is, they see no reason to expand.

This occurs during a recession.

Thus, government borrowing is unlikely to crowd out private spending when the economy is in a recession.

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Automatic stabilizers

Fiscal policy: Increase G and reduce T in a recession Cut G and raise T when inflation is the problem

Some of this occurs automatically, without additional action by Congress or the executive branch

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In a recession, people lose jobs. Payments for unemployment insurance rise More households become eligible for low-income

assistance (Medicaid, TANF, food stamps, other programs). Some begin social security payments.

Fewer taxes are collected

Point: government spending rises and taxes decline during a recession

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During an inflationary gap caused by high aggregate demand, unemployment is very low Payments for unemployment insurance drop Fewer households become eligible for low-income

assistance (Medicaid, TANF, food stamps, other programs). Workers delay social security payments.

More taxes are collected

Point: government spending declines and taxes rise when output > potential output

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The rise of government spending during a recession and decline in an inflationary gap are examples of automatic stabilizers.

The recession/inflation would be more severe without the automatic stabilizer.

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Budget deficits

When government spending > tax revenue, the government has a budget deficit.

When government spending < tax revenue, the government has a budget surplus.

When government spending = tax revenue, the government budget is balanced.

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Budget deficits

When the government budget is in deficit, the government borrows.

When the government budget is in surplus, the government pays off some debt.

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Budget deficits

Ideally, budget deficits should occur during recessions budget surpluses should occur during inflationary

gaps

Result: the government budget balances in the long-run (but not every year)

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Budget deficits as percent of GDP

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Federal spending as percent of GDP

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Federal revenue as percent of GDP

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Federal spending and revenue as percent of GDP

Year Spending

Revenue Deficit

2009 24.4% 14.6% -9.82014 20.2% 17.4% -2.8

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Budget deficits and debt

But policymakers tend to spend more (or cut taxes) in most years, both during recessions and expansions.

Result: climbing national debt

National debt is the sum of past budget deficits and surpluses

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Example:

Federal debt 2013: $12,300 billion

Deficit end of 2013: $ 700 billion

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Example:


Deficit end of 2013: $ 700 billion


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How much debt is too much?

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Measures:

Debt as percent of income

Interest payments as percent of income

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Federal debt as percent of GDP

101% in 2014

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Interest payments as percent of GDP

1.3% in 2014

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Do you have difficulty borrowing?

Does the U.S. government have difficulty borrowing?

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How is the debt paid back?

The government must run budget surpluses.

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Long-term forecast by Congressional Budget Office

Billions of dollars

2014-2023

Revenues 40,336

Outlays

Discretionary 12,790

Mandatory 28,670

Net interest 5,216

TOTAL 46,676

DEFICIT (6,340)

Source: CBO

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Long-term budget issues

Mandatory spending – occurs without any action by Congress (Medicare, social security, Medicaid, income maintenance programs)

Discretionary spending – Congress decides funding each year (defense, transportation, education, foreign aid, others)

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Goal: reduce the 2023 projected deficit of $6.3 trillion to zero

How can we accomplish this goal?

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Goal: reduce the 2023 projected deficit of $6.3 trillion to zero

How can we accomplish this goal?

Cut spending?

Increase taxes?

A mix of the two?

Fiscal policy topics 1 Sources of Federal revenue and expenditures Expansionary and contractionary...

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