11/17/2018. FISCAL POLICY Government Spending and Tax Policy Part 1. The Federal Budget. In this chapter:

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1 13 FISCL POLICY Government Spending and Tax Policy Part 1 In this chapter: Look at the federal budget history of outlays, receipts, deficits, and debt Explain the supply-side effects of fiscal policy supply side economics Review how fiscal stimulus is used to fight a recession Federal budget - statement of federal government s outlays and tax revenues. Has two purposes: 1. Finance federal government programs and activities 2. chieve macroeconomic objectives Fiscal policy - use of the federal budget to achieve macroeconomic objectives, such as full employment, economic growth, and price stability. 1

2 The Employment ct of 1946 Fiscal policy framework... it is the continuing policy and responsibility of the Federal Government to use all practicable means... to coordinate and utilize all its plans, functions, and resources... to promote maximum employment, production, and purchasing power. Government Receipts come from: (1) personal income taxes, (2) Social Security taxes, (3) corporate income taxes, (4) indirect taxes. Personal income taxes are the largest source of receipts. Government Outlays are: (1) transfer payments, (2) expenditure on goods and services, (3) interest of the debt. Transfer payments are the largest item of outlays. 2

3 Surplus or Deficit udget balance equals receipts minus outlays (T (G + Transfers)) or ((T Transfers) - G) If receipts (T) exceed outlays, the government has a budget surplus. If outlays exceed receipts, the government has a budget deficit. If receipts equal outlays, the government has a balanced budget. The budget deficit in fiscal 2017 was $655 billion and $779 billion in It was $1,300 billion in % 33.5% 15.3% 8.4% 63.7% 24.8% 11.5% Revenues and outlays as percent of GDP nominal terms. 3

4 Government debt is the total amount that the government has borrowed. It is the sum of past deficits minus past surpluses. the federal government s gross debt... and net debt. pd/mspd/2018/opds pdf Debt and Capital usinesses use debt to buy assets that yield a return (hopefully greater than interest cost). The government uses debt to buy assets that yield a social return - hopefully greater than the interest cost. ut, a lot of government debt is incurred to finance consumption and transfer payments with little or no social return. State government spending on highways, education, etc. yield a social return. Effects of Fiscal Policy How do taxes on personal and corporate income affect real GDP? Some economist argue the effect to be large. They thus argue fiscal policy has important effects on employment, potential GDP, and aggregate supply -called supply-side effects. 4

5 Effects of Fiscal Policy We use tools developed in chapter 6 to determined how full employment quantity of labor and potential GDP are determined. We first show the supply-side effect of the imposition of an income tax on the full employment quantity of labor and potential GDP change. We then look at the possible supply-side effects of lowering taxes on the full employment quantity of labor and potential GDP. We start without taxes. ssume equilibrium employment is full employment at 250 million. LS is labor supply. LD is labor demand. - chapter 6 stuff. The Effects of an income tax is to reduce the supply of labor. n income tax drives a wedge between the cost of labor to employers and employee take home pay. The supply of labor decreases because the tax decreases the aftertax wage rate reducing the incentive to work. 5

6 The before-tax real wage rate rises, but the after-tax real wage rate falls. The quantity of labor employed decreases. The gap created between the before-tax and after-tax wage rates is called the tax wedge. Note: This example uses a high tax rate, $15 tax on a $35 wage rate - a 43% tax rate. lower tax rate would have a smaller affect. When the quantity of labor employed decreases, potential GDP decreases. The supply-side effect of the income tax is to decrease potential GDP and decrease aggregate supply. When economist estimate potential GDP they consider taxes currently in place. Side Note: In chapters 10,11 and 12 we discussed the demand side effects of tax policy. Lower autonomous T => Yd = C = D = Y and P This is short-run policy aimed at increasing D. Talked about multipliers and that neat stuff. Notice the next slide title refers to tax rates (t) 6

7 Supply-Side Economics Proposes Lower Tax Rates Supply-siders feel income taxes weaken the incentive to work. They propose lowering income tax rates (t) to increase the incentive to work which increases the supply of labor and potential GDP. Lowering income taxes reverse everything on the earlier slides. This is a long-run policy aimed at shifting the LS to the right. Supply-Side Economics Proposes Lower Tax Rates Supply-siders also propose lower corporate income tax rates to increase incentive to invest. ig question is how large is the effect on aggregate supply. No consensus on how strong the supply-side effect is. Keynesians and Supply Siders Compared 7

8 LS 0 SS 0 11/17/2018 Keynesians argue lower taxes increase D: Chapter 10, 11 and 12 analysis. P P 1 P 0 D 0 D 1 In the SR: T => Y d =>C => D => Y and P. Move from point to. Y pot Y 1 Y Keynesians Long Run P SS 1 LS 0 SS 0 P 3 P 2 P 0 C D 0 D 1 Y pot Y In LR: Y returns to Y pot and the multiplier = 0. ut, both the deficit and debt increase because the government borrows to finance the tax cut. Supply Siders say lower tax rates (t) shift D right ND also shift LS and SS to the Right SS 1 P SS LS 2 0 LS1 SS 0 P 3 P 4 P 2 P 0 C D D 0 D 1 Y pot Y pot1 Y In LR, Y pot increases to Y pot1. P does not rise as much (P 4 compared to P 3 ) and the multiplier in the long-run > 0. lso, tax revenues increase as Y increases T = (t x Y) as potential GDP increases. The deficit does not increase as much. 8

9 ig Question How large is the supplyside effect on S? P LS 0 LS 1 SS 0 P 2 P 3 P 0 C D 1 D 0 If small, closer to point C. If larger, closer to point. Y pot Y pot1 Y Taxes and the Incentive to Save and Invest Interest income is currently taxed Premise: tax on interest income lowers the quantity of saving and investment and slows the growth rate of real GDP. The interest rate that influences saving and investment is the real after-tax interest rate. To calculate the real after-tax interest rate, we subtract the income tax paid on nominal interest income. Taxes and the Incentive to Save and Invest Interest income is currently taxed If nominal interest rate is 5% and tax rate (t) is 25%, the after tax nominal interest rate is: 5% - (.25 x 5%) = 3.75%. If inflation is 2%, subtract inflation to get the real after-tax interest rate: 3.75% % = 1.75% 9

10 Income tax on interest and capital income reduces the supply of loanable funds and raises interest rates and discourages investment. Have a tax wedge driven between the real interest rate and the real after-tax interest rate. Saving and investment fall from $2 trillion to $1.8 trillion. Lower investment means lower capital stock which means lower potential GDP. Supply-Side Economics Supply-siders propose lowering personal and corporate taxes on interest and capital income in order to increase saving and investment. Supply of loanable funds shifts to the right, interest rates are lower and investment increases. Capital stock increases and potential GDP increases. LS shifts to the right. Impact on Loanable Funds real interest rate SLF 4% 3% SLF lower tax rate DLF $1.8 $2.0 loanable funds (Trillions$) SLF increases, the real interest rate decreases and investment increases 10

11 Impact on Potential GDP P LS 0 LS 1 SS 0 P 0 P 1 SS 1 D 0 Increased Investment => capital stock increases and potential GDP increases. LS shifts to the right. Y pot Y 11