Macroeconomics in the World Economy: Theory and Applications Topic 4: Fiscal Policy

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1 Macroeconomics in the World Economy: Theory and Applications Topic 4: Fiscal Policy Dennis Plott University of Illinois at Chicago Department of Economics Spring 2014 Plott (ECON 221) Spring / 64

2 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Spring / 64

3 Goals & Readings Goals and Questions (a small sample) Define and discuss budget deficits and Government debt. Discuss Ricardian Equivalence Can Government budgets be compared to a household budget? How are the challenges to entitlement programs (e.g. Social Security) likely to affect the macroeconomy? Examine political cycles and volatility from discretionary spending. Readings Abel, Bernanke, Croushore Ch. 15, but skip section 15.4 Plott (ECON 221) Spring / 64

4 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Fiscal Policy Spring / 64

5 Example 4: Suppose Government Spending Rises Suppose Government spending increases (and no effect on Y ). Desired saving decreases, increasing the real interest rate that clears the goods market. IS curve will shift rightward. r r 0 IS Y 0 Y Plott (ECON 221) Fiscal Policy Spring / 64

6 Fiscal Policy: Government Enters the Picture The last graph was a simple example of how G can enter the picture in influencing the goods market equilibrium. What is the role of Government? This topic on Fiscal policy. Monetary policy will be covered next in Topic 5. We start from the components of government budget. Then shift our attention on how they can be used. Government Expenditures; Government Receipts; Government Deficit and Surpluses. Government Debt. Plott (ECON 221) Fiscal Policy Spring / 64

7 Outlays of the U.S. Government (G + Tr + INT) approximately 40% of GDP (Y ). Government purchases of goods and services. Government Investment (1/6 of total) in capital goods and consumption (5/6). Huge jumps during WWII, Korea, Vietnam, Gulf Wars. Transfer payments. (Social Security, welfare, unemployment insurance). Increasing steadily after Why? Interest payments to holders of Government Debt (net of interest received). Very sharp increase to repay War debt after WWII. But also high in the periods of high interest rates ( ). Relatively small government in the U.S. (G + Tr + INT) about 56% of GDP (Y ) in Sweden; for example. Plott (ECON 221) Fiscal Policy Spring / 64

8 Total Revenues and Outlays as a Percentage of Gross Domestic Product, Federal Government only. Plott (ECON 221) Fiscal Policy Spring / 64

9 Decomposition of Total Revenues as Percentage of GDP: Plott (ECON 221) Fiscal Policy Spring / 64

10 Federal Income Taxes as Percentage of GDP: The income tax on individuals is the federal government s principal source of funds to cover its outlays. First U.S. income tax law was enacted in Effectively from 1913, but de facto introduced after WWII. Plott (ECON 221) Fiscal Policy Spring / 64

11 Federal vs. State Government In 2005 Federal Government was about $2,520 billion; State Government was about $1,544 billion. FED IN: The income tax on individuals is the federal government s principal source of funds to cover its outlays. In 1999 income taxes brought in about 48% of total federal revenues, 42% in Second place are Contributions to Social Insurance 39% in FED OUT: Transfer Payments are the federal government s principal outlay. 44% of total in Second place is government purchases 30% in 2005, 2/3 of which was Defense. Also a good 15% of outlays is dedicated to transfers to the State Governments (Grants in Aid). STATE IN: Grants in Aid received from the Fed are only 23% of total revenues for State Governments. The bulk (54% in 2005) comes from Sales Taxes. Income taxes account for only 18%. STATE OUT: State Governments main outlay are government purchases 74% in 2005, especially spending in education. Transfer payments are the state government s second outlay: 26% of total in Plott (ECON 221) Fiscal Policy Spring / 64

12 Federal Government Finances: 2010 & 2011 (in billions of U.S. $) sheets.html Plott (ECON 221) Fiscal Policy Spring / 64

13 Federal Government Finances: 2010 & 2011 (in billions of U.S. $) sheets.html Plott (ECON 221) Fiscal Policy Spring / 64

14 How the U.S. Federal Government Budget Comes About In the U.S. each year the President proposes a Budget plan to Congress in early February. The U.S. Congress operates in 3 steps: 1 First, Lawmakers decide on the overall level of spending and taxes. 2 Second, they divide that overall figure into separate categories for national defense, health and human services, and transportation, for instance. 3 Third, Congress considers individual appropriations bills spelling out how the money in each category will be spent. Each appropriations bill ultimately must be signed by the President in order to take effect. Congress usually does not complete its work on appropriations bills until September. Most Lobbying activities are directed to Budget and Appropriations Committee. Plott (ECON 221) Fiscal Policy Spring / 64

15 Fiscal Policy Fiscal policy is the use of government spending (G) and taxes (τ n,τ c,τ k, tariffs, etc.) to stabilize the economy. Expansionary fiscal policy (i.e. G and/or τ n ) is used to boost the economy. Contractionary fiscal policy (i.e. G and/or τ n ) is used to slow the economy down. Governments can have: Output targets Price targets Unemployment targets. Stabilizing the economy means moving the economy towards its targets. We will ignore price targets for now (we have no prices in our model yet). Suppose the government has an output target and suppose that target is Y (we will also explain why Y is a good target later in the course). Fiscal policy is the manipulation of G and τ n to move the economy towards Y. (Assumes government knows where Y is policy later) we will discuss other drawbacks to fiscal later). Plott (ECON 221) Fiscal Policy Spring / 64

16 Example of Fiscal Policy: Consumer Confidence Falls Government can undo the decline in consumer confidence by increasing G or decreasing τ n (if agents are non-ricardian) this is fiscal policy. Compute Change in G: If G = consumer confidence, Y will remain unchanged (taking r as fixed) r r 0 IS Y 0 Y Plott (ECON 221) Fiscal Policy Spring / 64

17 Government Spending, Taxes, and the Macroeconomy Discretionary fiscal policy: deliberate changes in taxes (tax rates) and government spending by Congress and/or the President to promote full employment, price stability, and economic growth. The President is aided by the Council of Economic Advisers (CEA): A group of three persons that advises and assists the president of the United States on economic matters (including the preparation of the annual Economic Report of the President). Former chairs of the CEA: Ben Bernanke (former chairman of the Federal Reserve) Janet Yellen (current chairman of the Federal Reserve as of 1 st February 2014) Plott (ECON 221) Fiscal Policy Spring / 64

18 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Multipliers Spring / 64

19 Example of Fiscal Policy: Consumer Confidence Falls (Continued) [Solving for Y ] Y = C + I + G Y = C + I + G Y = C + G Y = MPC Y + G ( ) 1 Y = G 1 MPC income-expenditure identity (closed) in changes because I is exogenous because C = MPC Y solve for Y Plott (ECON 221) Multipliers Spring / 64

20 The Government Purchases Multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the government purchases multiplier equals: Example: If MPC = 0.8, then Y G = 1 1 MPC Y G = = = 5 An increase in G causes income to increase five times as much! Plott (ECON 221) Multipliers Spring / 64

21 Why the Multiplier Is Greater Than 1 Initially, the increase in G causes an equal increase in Y : Y = G. But Y = C = further Y = further C = further Y So the final impact on income is much bigger than the initial G. Plott (ECON 221) Multipliers Spring / 64

22 Example of Fiscal Policy: Consumer Confidence Falls (Continued) [Solving for Y ] Y = C + I + G Y = C + I + G Y = C Y = MPC ( Y T) Y = MPC 1 MPC T income-expenditure identity (closed) in changes I and G are exogenous Plott (ECON 221) Multipliers Spring / 64

23 The Tax Multiplier Definition: the change in income resulting from a $1 increase in T: Y T = MPC 1 MPC Example: if MPC = 0.8, then the tax multiplier equals: The tax multiplier is Y T = = = 4... negative: a tax increase reduces C, which reduces income.... greater than one (in absolute value): a change in taxes has a multiplier effect on income.... smaller than the govt spending multiplier: consumers save the fraction (1 MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. Plott (ECON 221) Multipliers Spring / 64

24 The Balance Budget Multiplier The government multiplier equals Y G = 1 1 MPC The tax multiplier equals Y T = MPC 1 MPC A balanced budget multiplier consists of equal changes in G and T The balanced budget multiplier equals balanced budget multiplier = Y G + Y T balanced budget multiplier = balanced budget multiplier = 1 MPC 1 MPC balanced budget multiplier = MPC + MPC 1 MPC Plott (ECON 221) Multipliers Spring / 64

25 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Deficits & Debt Spring / 64

26 U.S. Federal Budget Deficit Share Plott (ECON 221) Deficits & Debt Spring / 64

27 Types of Deficits When outlays exceed revenues, there is a deficit; when revenues exceed outlays, there is a surplus. The total deficit tells the amount the government must borrow to cover all its expenditures. Formally: deficit = outlays tax revenues deficit = government purchases + transfers + net interest tax revenues deficit = (G + TR + INT) T The primary government budget deficit excludes net interest payments; i.e. (G + TR) T. The primary deficit tells if the government s receipts are enough to cover its current purchases and transfers. The primary deficit ignores interest payments because those are payments for past government spending. The structural budget deficit is the deficit that would exist in the economy that would occur at potential output Y. Cyclical deficits = actual deficits structural deficits. The difference is due to automatic stabilizers (provisions in the budget that increase outlays in recessions and revenues in booms automatically). For example, taxes are high when the economy expands and low when it contracts or unemployment transfers are low when the economy expands and high when it contracts. Plott (ECON 221) Deficits & Debt Spring / 64

28 Types of Deficits (Continued) In general: Deficits are countercyclical! (They rise when Y falls and fall when Y rises) Even if the government has a policy (combination of G and T) that would lead to no deficits at Y (the target level of output for the economy), deficits could still occur (the reason: Y does not always equal Y ). Why do we get countercyclical deficits? Automatic Stabilizers! Welfare Payments, Unemployment Insurance, and Tax System dampen the effects of consumption over the business cycle. Again: T goes up when times are good (like in the late 1990s). G goes up when times are bad (welfare payments). Tr Given Automatic Stabilizers (and potentially proactive governmental fiscal policies), cyclical deficits seem to be an inherent part of our economy. Plott (ECON 221) Deficits & Debt Spring / 64

29 Should Governments Try To Prevent Deficits? Balance Budget Amendments Examples: U.S. Balanced Budget Amendment. Criteria for entry to EMU that deficit/gdp be 3% or less and that debt/gdp be 60 Benefits: limit spending. If it spends today, government must: 1 raise taxes now (changing taxes frequently creates economic uncertainty; distorts signals/incentives) 2 raise taxes in the future (higher taxes also cause incentives to be distorted) 3 print money in the future (could lead to (hyper)inflation) Is there a cost? Yes balanced budget amendments can make economic situations worse. Example: suppose consumer confidence falls. As Y falls, tax revenues fall. As tax revenues fall, deficits (cyclical) increase. If the government has to balance the budget, it would either have to cut G or increase T both of which would cause the IS curve to shift further to the left. Conclusion it may be bad to have policies requiring governments to eliminate all deficits, but there may be some benefits from eliminating structural deficits. Plott (ECON 221) Deficits & Debt Spring / 64

30 Costs and Benefits of Government Spending Consumption G Governments can provide services that may be inefficiently provided in private sector (i.e., police protection, parks, post office, etc). Investment G Governments can provide investment that is used as an input into other production (i.e., Highway and transportation infrastructure, bridges, enforce property rights). Training and education G (another form of investment G = increase human capital) Governments can train the work force (i.e., student loan programs, public education, state colleges, etc.). Cost of Government spending? diverts resources from private sector. Benefits of Government spending? (potentially) helps increase A in a country (roads, property rights, skilled labor, NSF grants). Provides goods not provided in market place. Must compare the benefits to the costs of government spending. Plott (ECON 221) Deficits & Debt Spring / 64

31 Public Debt The US national debt (approximately) on 9 th February 2014: $17,321,815,752, Your approximate share of the national debt: $54, Debt = Total Value of Government Bonds Outstanding at a Particular Time Debt = Deficit If Government is spending more than it receives (there s a budget deficit), total debt has to go up. If the economy s nominal growth is strong then the ratio Debt/Nominal GDP goes down. The relationship between Deficit and Debt: ( ) ( Debt Deficit = Nominal GDP Nominal GDP Debt Nominal GDP ) Growth of Nominal GDP Plott (ECON 221) Deficits & Debt Spring / 64

32 Student Debt Plott (ECON 221) Deficits & Debt Spring / 64

33 Public Debt (Continued) Prove the relationship between Deficit and Debt: ( ) ( ) Debt Deficit = Nominal GDP Nominal GDP Debt Growth of Nominal GDP Nominal GDP Define: Q = B py = Debt Nominal GDP Start from the growth rate of the Debt/Nominal GDP ratio, Q Q = B B (py ) py Multiply both sides by Q: Q = B py B py (py ) py ( Y Q = B py B py Y + p p ) Plott (ECON 221) Deficits & Debt Spring / 64

34 U.S. Federal Debt Held by the Public as a Percentage of GDP Plott (ECON 221) Deficits & Debt Spring / 64

35 The Burden of Government Debt: False Concerns Can the federal government go bankrupt? The government does not need to raise taxes to pay back the debt since it can borrow more (i.e. sell new bonds) to refinance bonds when they mature. Corporations use similar methods they almost always have outstanding debt. The government has the power to tax, which businesses and individuals do not have when they are in debt. Does the debt impose a burden on future generations? The public debt is a public credit your grandmother may own the bonds on which taxpayers are paying interest. Some day you may inherit those bonds that are assets to those who have them. If the spending is for productive purposes it will enhance future earning power and the size of the debt relative to future GDP and population could actually decline. Borrowing allows growth to occur when it is invested in productive capital. Plott (ECON 221) Deficits & Debt Spring / 64

36 The Burden of Government Debt: Substantive Issues Repayment of the debt affects income distribution. If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality. Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers. A higher proportion of the debt is owed to foreigners (e.g. China) than in the past, and this can increase the burden since payments leave the country. Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear. There are some positive aspects of borrowing even with crowding out. If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose. Public investment makes private investment more attractive. For example, new federal buildings generate private business; good highways help private shipping, etc. Plott (ECON 221) Deficits & Debt Spring / 64

37 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Ricardian Equivalence Spring / 64

38 Are Deficits Bad, Part 2: Ricardian Equivalence Hold the amount of G constant. Assume that current taxes exactly finance this level of spending and debt is zero. Assume people live forever (not as absurd as it sounds; think of children and their children, etc.) and it is possible to borrow and lend at r. Suppose now the Government decides to cut taxes and the Government instead floats debt B to finance the spending today. Question: what do you think is going to happen to consumption and saving? Do you think that the extra disposable income is going to be saved or consumed? Hint: we know that under PIH people care about PVLR. Has that changed? Plott (ECON 221) Ricardian Equivalence Spring / 64

39 Ricardian Equivalence Ricardian Equivalence: theory that states that consumers behavior is equivalent regardless if the government finances G (government expenditures) through increased taxes or through increased debt B. (Take money from consumers today higher T, or take money from them tomorrow to repay (1 + r)b, the PVLR is unchanged). If the government floats debt to finance the spending today, (forward looking) consumers realize that the government, at some time in the future, will have to raise taxes to pay back the debt. As a result, a reduction in taxes today (for given G today) will be seen as being accompanied by higher taxes in the future. Households will save today to fund the future tax increases (they expect disposable income in the future to fall). National Saving would remain unchanged. Does this theory hold empirically? NO! Private Saving was falling during the large deficits of the 1980s. People, when asked, tend not to think this way. Plott (ECON 221) Ricardian Equivalence Spring / 64

40 Ricardian Equivalence Recall from Topic 3 that Bender maximize U(c,c f ) in a two period model (current = period 1, future = period 2) U( ) = ln(c) + βln(c f ) (log utility for simplification, β = Discount Factor; i.e., how much you like eating today versus tomorrow) c f = (y + a + B c)(1 + r) T(1 + r) + y f (Budget Constraint; a = Initial Wealth) but B = T So c + cf 1 + r = a + y + yf (I just re-wrote the above constraint) 1 + r Same optimization as in Topic 3 without taxes T and debt B: maximize U( ) subject to budget constraint. Plott (ECON 221) Ricardian Equivalence Spring / 64

41 Ricardian Equivalence: Consumption Continued Why Doesn t it hold: Myopia; Liquidity Constraints; High Levels of Impatience (pull of instant gratification); Do not care about bequests/future generations; Timing of taxes is important (taxes are not lump sum). If Ricardian Equivalence did hold, running a deficit would not affect national savings for the economy. In this case (with a closed economy), I = S, so Investment would not change. A tax cut would be entirely saved. If Ricardian Equivalence did not hold, decreasing T could cause C to increase (an income effect). A tax cut could be mostly consumed. Plott (ECON 221) Ricardian Equivalence Spring / 64

42 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Entitlement Programs Spring / 64

43 Sustainability of the U.S. Government Spending Plott (ECON 221) Entitlement Programs Spring / 64

44 The Fiscal Problem of the 21 st Century Plott (ECON 221) Entitlement Programs Spring / 64

45 The Fiscal Problem of the 21 st Century doc8935/01-24-senate_testimony.pdf Plott (ECON 221) Entitlement Programs Spring / 64

46 Implement a Social Security Program Consider two PIH adults who are similar in all respects (lifetime resources, life span, timing of income, etc.) except the first is in period 1 of her life and the second is in period 3 of her life (suppose all households only live three periods: young worker, mature worker and retired). Here are their income/consumption/saving profiles. Each live three years; r = 0, β = 1, a = 0 (assume same utility function from before; i.e., smooth consumption). Period Income Consumption Saving Plott (ECON 221) Entitlement Programs Spring / 64

47 Implementing a Social Security Program Suppose the government unexpectedly taxes the young $3 this period (i.e. temporary) to give to the old. (The old get $3). Current tax receipts from workers are used to pay current benefits to retirees (pay-as-you-go system). What happens to the consumption of the young? Nothing: PVLR has not changed. What happens to saving of the young. Young save less now than they otherwise would ( 3 now compared to 0 before). What happens to the consumption of the old? It increases consumption by $3 in the last period of their life. Saving does not change (they dissave $8 in both cases). Total Saving for society falls by $3 and consumption increases by $3 at the time the program is implemented. Note: like expected income increases, expected transfers have no effect once they are implemented. Plott (ECON 221) Entitlement Programs Spring / 64

48 Reforming the Social Security Program In a pay-as-you-go system the size of the young cohort that pays taxes has to be larger or comparable to the size of the retirees. If there is a discrepancy, the government has to make up the difference by increasing taxes. In reality it emits IOU s (e.g. bonds) that later repays. Suppose now you want to move to a fully funded Social Security system. An example are Private Retirement Accounts PRAs. What happens to the consumption of the old? They paid the $3 when young. However if we are going to fully fund the young, the old won t get their whole $3. Why? We increased consumption to the old by $3 in the last period of their life without them paying enough contributions (actually 0). Plott (ECON 221) Entitlement Programs Spring / 64

49 Reforming the Social Security Program (Continued) In a pay-as-you-go system the size of the young cohort that pays taxes has to be larger or comparable to the size of the retirees. To move to a fully-funded system a cut (at least partial) of the benefit for current retirees is necessary. This is the main problem in reforming Social Security systems in Europe. Current generation of next-to-retirement would be left without a pension. For this reason most transition democracies in Central and Eastern Europe (e.g. Bulgaria, Hungary, Latvia, Poland, Russia) chose to complement their Social Security systems with individual retirement schemes. Employees and, in some cases, employers must contribute a certain percentage of earnings to an individual account managed by a public or private fund manager chosen by the employee. Plott (ECON 221) Entitlement Programs Spring / 64

50 Reforming the Social Security Program (Continued) The old-age dependency ratio is the ratio of the population aged 65 years or over to the population aged All ratios are presented as number of dependents per 100 persons of working age (20 64). Plott (ECON 221) Entitlement Programs Spring / 64

51 The Effects of Taxes on Incentives Substitution and income effects of income taxes. Total Taxes Paid Average Tax Rate = Before-Tax Income Marginal Tax Rate: tax on the additional $1 of income (i.e. on the marginal dollar). The maximum effective marginal income tax rate is around 39.6 percent for taxpayers, depending on their level of deductions. Increase average tax rate, keep marginal tax rate constant: Income effect labor supply increases (you are poorer, consume less leisure). Increase marginal tax rate, keep average tax rate constant: Substitution effect labor supply decreases (leisure is cheaper, consume more leisure). Plott (ECON 221) Entitlement Programs Spring / 64

52 The Effects of Taxes on Incentives: Examples 1981 ERTA Tax cut decreased the average tax rate and decreased the marginal tax rate: Income effect labor supply decreases (you are richer, consume more leisure). Substitution effect labor supply increases (leisure is more expensive, consume less leisure). Empirical result: no effect on labor supply Tax Reform Act kept a constant average tax rate, but decreased the marginal tax rate: Income effect None. Substitution effect labor supply increases (leisure is more expensive, consume less leisure). Empirical result: increase in labor supply. Plott (ECON 221) Entitlement Programs Spring / 64

53 Supply Side Economics: The Effect of Taxes on Incentives Emphasizes substitution effects of marginal tax rates. Says people would work more if τ n were lower and would save more if τ s were lower. Where they are wrong: tax cuts (lower τ n, τ s and lower T) have income effects which can potentially dominate. N falls (and S falls). Where they are right: tax reforms (lower τ but T = 0) do not have income effects. N and S (efficiently) rise. Where they may be right: positive effects on human capital investment? Gary Becker and Robert Lucas of the University of Chicago think so. Plott (ECON 221) Entitlement Programs Spring / 64

54 Notes on Supply Side Economics By tax reform economists mean revenue-neutral reform in the way taxes are collected. In some flat tax proposals this involves eliminating tax deductions (e.g. home mortgage interest) and lowering income tax rates. To see how this can be revenue-neutral, suppose T = τ n (Y D) where D = tax deductions. One can lower τ n and D so that, for a given Y, T will be unchanged. Tax reforms that lower τ n have substitution effects, but no income effects since T = 0. Such Tax Reforms have positive effects on labor supply and on private saving (with no negative effects on government saving). Why is increasing N and S efficient? Because, relative to an efficient tax code, the existing tax code discourages N and S(household). The most efficient (but not necessarily the most fair or feasible) tax code would be a lump sum tax on all individuals: every individual would pay the same tax. Thus individuals would face zero marginal tax rates they could keep 100% of marginal income. The current tax code has positive marginal tax rates and lots of deductions. Moving from the current tax code to a lump sum tax would be a Tax Reform with positive substitution effects. Thus, compared to the efficiency ideal of a lump sum tax, the current tax code encourages people to substitute away from N and S(household). Plott (ECON 221) Entitlement Programs Spring / 64

55 Taxes Affect Social Security through Incentives to Work Note: the implicit tax rates take into account incentives in both old-age pension and unemployment-related benefit systems. Plott (ECON 221) Entitlement Programs Spring / 64

56 Other Direct Incentives: Tax System Simplification See "The Case for Flat Taxes" The Economist 14 th April 2005 for a favorable analysis of the introduction of a flat tax in Russia. Plott (ECON 221) Entitlement Programs Spring / 64

57 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Recent Debates Spring / 64

58 Austerity Definition Austerity: official actions taken by the government, during a period of adverse economic conditions, to reduce its budget deficit using a combination of spending cuts or tax rises. Various austerity measures have been announced since the global recession in 2008 and the Eurozone crisis in Austerity policies may be attempts to demonstrate governments liquidity to their creditors and credit rating agencies by bringing fiscal incomes closer to expenditures. The debt ceiling is a limit on how much money the federal government can borrow. Raising the debt ceiling is routine; Congress has voted to raise the debt ceiling 19 times since Actually crossing the debt deadline has happened three times in the past three years, forcing the government to move money around to avoid hitting the ceiling. The debt limit was originally created so Congress would not have to approve every single bond issue. Plott (ECON 221) Recent Debates Spring / 64

59 Austerity (Continued) The U.S. fiscal cliff was a simultaneous increase in tax rates and decrease of government spending through budget sequestration that would have occurred through a series of previously enacted laws. Treasury Secretary Jack Lew estimates the U.S. Treasury will run out of special accounting maneuvers by 27 th February 2014 to ensure all the country s bills are paid in full and on time; i.e. the debt ceiling must be raised. "It s like deja-vu, all over again." Yogi Berra Budget sequestration is a procedure under U.S. law that limits the size of the federal budget. Sequestration involves setting a firm limit on the amount of government spending within broadly-defined categories. If Congress enacts annual appropriations legislation that exceeds these caps, an across-the-board spending cut is automatically imposed on these categories, affecting all departments and programs by an equal percentage. The amount exceeding the budget limit is held back by the Treasury and not transferred to the agencies specified in the appropriation bills. Plott (ECON 221) Recent Debates Spring / 64

60 Outline 1 Topic 4: The Role of Government and Fiscal Policy Fiscal Policy Multipliers Deficits & Debt Ricardian Equivalence Entitlement Programs Recent Debates Fiscal Policy Complications Plott (ECON 221) Fiscal Policy Complications Spring / 64

61 Problems, Criticisms and Complications Problems of timing Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence. Administrative lag is the difficulty in changing policy once the problem has been recognized. Operational lag is the time elapsed between change in policy and its impact on the economy. Miscellaneous political terms: Pork barrel spending: the act of using government funds on local projects that are primarily used to bring more money to a specific representative s district. Basically the politician tries to benefits his/her constituents in order to maintain their support and vote. Logrolling: the exchange of political support, particularly in the legislative process. Earmark: the act of setting something aside for a specific use or purpose in the future. For example, goods may be earmarked prior to being exported in the future. Most commonly used to refer to funds that have been set aside in order to pay for a specific project. congress-earmarks-legislation-spending/ / Plott (ECON 221) Fiscal Policy Complications Spring / 64

62 Hard at Work shirking: the behavior of a worker who is putting forth less than the agreed to effort; doing less than expected on the job. Plott (ECON 221) Fiscal Policy Complications Spring / 64

63 Problems, Criticisms and Complications: Crowding Out The crowding-out effect may be caused by fiscal policy. "Crowding-out" may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy. Some economists argue that little crowding out will occur during a recession. Economists agree that government deficits should not occur at full-employment, it is also argued that monetary authorities could counteract the crowding-out by increasing the money supply to accommodate the expansionary fiscal policy. Plott (ECON 221) Fiscal Policy Complications Spring / 64

64 Political Business/Budget Cycle Political considerations: Government has other goals besides economic stability, and these may conflict with stabilization policy. A political business (budget) cycle may destabilize the economy: election years have been characterized by more expansionary policies regardless of economic conditions. A political business cycle is the concept that politicians are more interested in reelection than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view the political process creates economic instability. State and local finance policies may offset federal stabilization policies. They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse. In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus. Plott (ECON 221) Fiscal Policy Complications Spring / 64