Economics 10020/20020 Principles of Macroeconomics The Government & Fiscal Policy

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1 on Economics 10020/20020 Principles of Macroeconomics & Dennis C. Plott University of Notre Dame Department of Economics Spring 2015 Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

2 on Defined Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. State taxes and spending are not generally aimed at affecting national-level objectives. Some forms of government spending and taxes automatically increase or decrease along with the business cycle; these are automatic stabilizers. Example: Unemployment insurance payments are larger during a recession. Discretionary fiscal policy, on the other hand, refers to intentional actions the government takes to change spending or taxes. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

3 on 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. 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 Reserve) Janet Yellen (current chairman of the Reserve as of 1 st February 2014) Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

4 on Expenditures as a Percentage of GDP As a percentage of GDP, federal expenditures are now higher than ever almost 25% of GDP. However a smaller proportion is now spent on government purchases of goods and services (mostly military spending). Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

5 on What Does the Spend Money On? purchases consist of defense spending and everything else, like salaries of FBI agents, operating national parks, and funding scientific research. Around half of federal expenditures are spent on transfer payments, like Social Security, Medicare, and unemployment insurance. rest is spent on grants to state and local governments to support their activities, like crime prevention and education; and on paying interest on the federal debt. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

6 on Outlays of the U.S. (G + Tr + INT) approximately 40% of GDP (Y ). purchases (G) of goods and services. Investment (1/6 of total) in capital goods and consumption (5/6). Huge jumps during WWII, Korea, Vietnam, Gulf Wars. Transfer payments (Tr). (Social Security, welfare, unemployment insurance). Increasing steadily after Interest payments (INT) to holders of (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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

7 on Total Revenues and Outlays as a Percentage of Gross Domestic Product, ( only) Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

8 on Congressional Budget Office (CBO) Established in 1975; signed into law by President Nixon in 1974 CBO produces independent analyses of budgetary and economic issues to support the Congressional budget process. Each year, the agency s economists and budget analysts produce dozens of reports and hundreds of cost estimates for proposed legislation. CBO is nonpartisan; conducts objective, impartial analysis; and hires its employees solely on the basis of professional competence without regard to political affiliation. CBO does not make policy recommendations, and each report and cost estimate summarizes the methodology underlying the analysis. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

9 on Where Does the Get Money From? majority of federal revenues come from taxes on individual employment: individual income taxes and payroll taxes earmarked to fund Social Security and Medicare. Taxes on corporate profits constitute about one-seventh of federal receipts. remainder of federal revenue comes from excise taxes (on cigarettes, gasoline, etc.), tariffs on imports, and other fees from firms and individuals. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

10 on Decomposition of Total Revenues as Percentage of GDP: Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

11 on Income Taxes as Percentage of GDP: 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

12 on How the U.S. Budget Comes About In the U.S. each year the President proposes a Budget plan to Congress in early February. 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

13 on How Much Spending Is? Before the Great Depression of the 1930s, most government spending was at the state or local level; now the federal government s share is two-thirds to three-quarters. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

14 on Expansionary in the AD-AS Model Expansionary fiscal policy involves increasing government purchases or decreasing taxes. Increasing government purchases directly increases aggregate demand. Decreasing taxes indirectly affects aggregate demand by increasing disposable income, and hence consumption spending. If the government believes real GDP will be below potential GDP, it can enact expansionary fiscal policy in an attempt to restore long-run equilibrium decreasing unemployment. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

15 on Contractionary in the AD-AS Model Contractionary fiscal policy involves decreasing government purchases or increasing taxes. This works just like expansionary fiscal policy, only in reverse. If the government believes real GDP will be above potential GDP, it can enact contractionary fiscal policy in an attempt to restore long-run equilibrium decreasing inflation. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

16 on Summarizing federal government s actions described on the previous slides constitute a countercyclical fiscal policy. Bear in mind that: effects described assume ceteris paribus: everything else is staying the same, including monetary policy. Contractionary fiscal policy is not really causing prices to fall; it s causing inflation to be lower than it otherwise would have been. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

17 on Aggregate Demand and the Multiplier Effect If the government increases its spending on goods and services, then aggregate demand increases immediately. This is the autonomous increase in aggregate demand. But then people receive this increased spending as increased income and increase their consumption spending accordingly. This is the induced increase in aggregate demand. series of induced increases in consumption spending that results from the initial increase in autonomous expenditures is known as the multiplier effect. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

18 on Multiplier Effect of an Increase in Purchases Suppose each increase in spending induces half again as much consumption spending. Over time, a $100 billion increase in government purchases will result in an additional $100 billion in induced consumption spending. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

19 on Multipliers for Taxes We can describe the total effect of a change (increase or decrease) in government purchases or taxes by measuring the change in equilibrium real GDP. Change in Equilibrium real GDP Purchases Multiplier = Change in Purchases Change in Equilibrium real GDP Tax Multiplier = Change in Taxes tax multiplier will be a negative number: an increase in taxes will decrease equilibrium real GDP, and vice versa. We expect the tax multiplier to be smaller (in absolute value) than the government purchases multiplier. Why? A $100 billion increase in purchases initially increases spending by $100 billion, but a $100 billion tax cut is partially spent and partially saved. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

20 on Effect of Changes in Tax Rates tax multiplier applies to changes in the amount of taxes, without changes in tax rates. Example: In 2009 and 2010, the federal government enacted the Making Work Pay Tax Credit: a $400 reduction in taxes for working individuals ($800 for households). Decreases in tax rates have a slightly different effect: 1. Increasing the disposable income of households, leading them to increase their consumption spending. 2. Increasing the size of the multiplier effect, since more of any increase in income becomes disposable income. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

21 on Taking into Account the Effects of Aggregate Supply An increase in aggregate demand will not only result in real GDP rising; it will also result in a price level increase, because the short-run aggregate supply curve is upward-sloping. Suppose that between the autonomous and induced effects, fiscal policy causes aggregate demand to increase by $1.2 trillion. resulting real GDP increase is smaller only $1.0 trillion. price level also rises. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

22 on Multipliers Work in Both Directions An increase in government purchases and a cut in taxes have a positive multiplier effect. A decrease in government purchases and an increase in taxes have a negative multiplier effect. Example: a reduction in government spending on defense initially affects defense contractors, but then it would spread to suppliers to and employees of those contractors, and then to other firms and workers. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

23 on Example of : Consumer Confidence Falls [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 Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

24 on 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! Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

25 on 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

26 on Example of : 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 Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

27 on 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: 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

28 on Balance Budget Multiplier government multiplier equals Y G = 1 1 MPC tax multiplier equals Y T = MPC 1 MPC A balanced budget multiplier consists of equal changes in G and T 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 Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

29 on Estimates of the Size of Multipliers How large are the multipliers for government purchases and for taxes? This question is very difficult to answer, and different economists produce different estimates: Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

30 on Estimates of the Size of Multipliers continued Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

31 on Budget Deficit, U.S. federal government does not generally balance its budget. Sometimes its revenues are higher than its expenditure, but usually the reverse is true especially during wartime. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

32 on Budget Deficits and Surpluses A budget deficit occurs when the government s expenditures are greater than its tax revenue. A budget surplus occurs when the government s expenditures are less than its tax revenue. As the graph on the previous slide indicates, budget deficits often occur during wartime. But they also occur during recessions, as tax receipts fall, and automatic stabilizers like increases in transfer payments (unemployment insurance, food stamps, etc.) take effect. se automatic stabilizers are important for limiting the severity of a recession; many economists believe that the Great Depression of the 1930s was more severe because most of these automatic stabilizers did not exist then. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

33 on How Large Is the Deficit in the United States? Currently, the federal government runs a budget deficit; the CBO estimated in 2013 that the deficit for 2014 would be about 3.5% of real GDP. How much of this deficit is due to the recession, and how much is due to government spending and tax policies? We can identify this by looking at the cyclically adjusted budget deficit or surplus: the deficit or surplus in the federal government s budget if the economy were at potential GDP. CBO estimated that the budget deficit would be 1.0% of real GDP in 2014 if real GDP were at its potential. So this is the amount that spending needs to be cut, or taxes raised, in order to bring the federal budget into balance in the long-run. rest is due to automatic stabilizers. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

34 on Did Fail during the Great Depression? expenditures increased after the Great Depression of the 1930s as part of the New Deal, enacted by Franklin D. Roosevelt. Similarly, there was a budget deficit each year in the 1930s (except 1937). However recovery from the Great Depression was painfully slow. Does this show that expansionary fiscal policy didn t work during the 1930s? In fact, when we cyclically-adjust the budget deficits of the 1930s, we find that the federal government was not using expansionary fiscal policy at all. It had a cyclically adjusted budget surplus instead. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

35 on during the Great Depression E. Cary Brown: Fiscal policy, then, seems to have been an unsuccessful recovery device in the thirties not because it did not work, but because it was not tried. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

36 on When the federal government runs a budget deficit, it finances its activities by selling Treasury securities. total value of those securities outstanding is known as the federal government debt, or the national debt. national debt increased dramatically as a percentage of GDP during the two world wars and the two worst recessions. It is now at its highest level since Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

37 on Is a Problem? For now, the federal government is at no serious risk of defaulting on its obligations, because: interest rate it can borrow money at is very low size of the interest payments on the debt is low relative to the size of the federal budget around 11% In the long-run, a debt that increases in size relative to GDP can pose a problem potentially crowding out investment, which is a key component of long term growth. This problem is reduced if the government debt was incurred to finance infrastructure, education, or research and development; these serve as a long term investment for the economy. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

38 on U.S. Budget Deficit Share Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

39 on Types of Deficits When outlays exceed revenues, there is a deficit; when revenues exceed outlays, there is a surplus. 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 primary government budget deficit excludes net interest payments; i.e. (G + TR) T. primary deficit tells if the government s receipts are enough to cover its current purchases and transfers. primary deficit ignores interest payments because those are payments for past government spending. 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. 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

40 on Types of Deficits (Continued) In general: Deficits are countercyclical! (y 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

41 on Should the Budget Always Be Balanced? Although many economists believe the federal budget should be balanced when the economy is at potential GDP, few believe it should be balanced during a recession. During a recession, tax revenues fall; to balance the budget, spending would have to fall also making the recession worse. In fact, some economists argue that the federal budget should normally be in deficit. Just as households and firms borrow money to implement long-term investments, they argue that the federal government should do the same. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

42 on Should s 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 AD 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

43 on Costs and Benefits of Spending Consumption G s can provide services that may be inefficiently provided in private sector (i.e., police protection, parks, post office, etc). Investment G s 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) s can train the work force (i.e., student loan programs, public education, state colleges, etc.). Cost of spending? diverts resources from private sector. Benefits of 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

44 on Public US national debt (approximately) on 2 nd March 2015: $18,142,003,632, Your approximate share of the national debt: $56, = Total Value of Bonds Outstanding at a Particular Time = Deficit If 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 /Nominal GDP goes down. relationship between Deficit and : ( Nominal GDP ) ( Deficit = Nominal GDP Nominal GDP ) Growth of Nominal GDP Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

45 on U.S. Held by the Public as a Percentage of GDP Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

46 on Burden of : False Concerns Can the federal government go bankrupt? 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. 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? 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

47 on Burden of : 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. re 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

48 on Does Spending Create Jobs? spending is a component of real GDP: Y = C + I + G + NX This makes it appear as though increases in government spending increase output and hence other relevant economic variables like employment. However some economists argue that government spending simply shifts employment from one group to another it does not increase total employment. This debate was particularly important after the recession: can the government use discretionary fiscal policy to increase employment? Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

49 on Can We Use to Stabilize the Economy? For several reasons, fiscal policy may be even less effective than monetary policy at countercyclical stabilization: Timing fiscal policy is harder, due to: Recognition lag: the time it takes to figure out that fiscal policy action is needed Law-making lag (Legislative delay): the time it takes Congress to pass the laws needed to change taxes or spending; Congress needs to agree on the actions Impact lag (Implementation delay): the time it takes from passing a tax or spending change to its effect on real GDP being felt; large spending projects may take months or even years to begin, even once approved. spending might crowd out private spending Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

50 on 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. earmarks article Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

51 on 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

52 on Political Business/Budget Cycle Political considerations: 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. y 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

53 on Crowding Out in the Short Run AD-AS Model Crowding out: A decline in private expenditures as a result of an increase in government purchases With the higher interest rate investment falls. So the initial increase in spending is partially offset by the crowding out. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

54 on Crowding Out in the Long-Run In the long-run, the increase in government purchases will have no effect on real GDP; the reduction in investment will exactly offset the increase in government purchases. Why? Because in the long-run, the economy returns to potential GDP, even without the government s intervention. long-run effect is simply to increase the size of the government sector within the economy. Bear in mind that the long-run may be many years away, however, so the intermediate increase in real GDP may be worth the cost. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

55 on in Action: Recession In early 2008, believing a recession was imminent, Congress authorized a tax cut: a one-time rebate of taxes already paid, totaling $95 billion. This resulted in a boost to consumers current incomes. Changes to current incomes result in smaller increases in spending than changes to permanent incomes, because people seek to smooth their consumption over time. Economists estimate that consumers spent about 33 40% of the rebates they received, so the tax cut resulted in about $35 billion in increased spending. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

56 on American Recovery and Reinvestment Act of 2009 In 2009, Congress passed the stimulus package, a combination of increased government spending (about two-thirds) and decreased taxes (about one-third). At $840 billion, the stimulus package was by far the largest fiscal policy action in U.S. history. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

57 on Effect of the Stimulus on the Budget effect of the stimulus package on federal expenditures and revenue was not immediate, but it mostly occurred over the following two years. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

58 on How Effective Was the Stimulus Package? When the stimulus was passed, Obama administration economists believed that by the end of 2010, it would: Increase real GDP by 3.5% Increase employment by 3.5 million By the end of 2010, real GDP actually rose by 4.4% but employment fell by 3.3 million. Did the stimulus fail? To judge the effect of the stimulus package, we have to measure its effects holding constant all other factors affecting real GDP and employment. Isolating the effects of the stimulus package is very difficult; economists still differ in their views about how effective the stimulus package was. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

59 on CBO Estimates of the Effects of the Stimulus Congressional Budget Office (CBO) is a non-partisan organization that estimates the effects of government policies. table shows CBO estimates of the effect of the stimulus package on economic variables, relative to what would have happened without the stimulus package: CBO s conclusion: the stimulus package reduced the severity of the recession but did not come close to bringing the economy back to full employment. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

60 on Why Was the Recession of So Severe? recession of was the worst recession to hit the United States since the Great Depression of the 1930s. Great Depression of the 1930s was accompanied by a financial crisis just like the recession of Are recessions generally worse when they are accompanied by a financial crisis? Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

61 on Recession of continued After studying recessions accompanied by financial crises worldwide, economists Carmen Reinhart and Ken Rogoff say that such recessions are much more severe than average. Most people did not see the financial crisis coming, so they also underestimated how severe the recession would be. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

62 on Social Security and Medicare: Fiscal Time Bombs? Entitlement Programs Social Security and Medicare have helped to reduce poverty among the elderly, while Medicaid helps improve the health of poor people. But the aging population and rising health care costs are combining to put those programs in jeopardy. Through 2090, the budget shortfall for these programs is estimated to be almost $60 trillion! Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

63 on Entitlement Programs Social Security and Medicare: Is re a Fix? How can these programs continue to exist? It is likely that a combination of these measures will eventually need to be adopted: Increasing taxes Decreasing benefits (including slower benefit growth, perhaps differently for different income groups) Decreasing eligibility (SSI age already increasing from 65 to 67) But perhaps the most important element will be finding a way to reduce medical costs. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

64 on Sustainability of the U.S. Spending Entitlement Programs Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

65 on Fiscal Problem of the 21 st Century Entitlement Programs Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

66 on Fiscal Problem of the 21 st Century Entitlement Programs senate_testimony.pdf Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

67 on Entitlement Programs 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. 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. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

68 on Reforming the Social Security Program (Continued) Entitlement Programs 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). Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

69 on Taxes Affect Social Security through Incentives to Work Entitlement Programs Note: the implicit tax rates take into account incentives in both old-age pension and unemployment-related benefit systems. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

70 on Other Direct Incentives: Tax System Simplification Entitlement Programs See " Case for Flat Taxes" Economist 14 th April 2005 for a favorable analysis of the introduction of a flat tax in Russia. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

71 on Entitlement Programs 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. 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. debt limit was originally created so Congress would not have to approve every single bond issue. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72

72 on Entitlement Programs Austerity (Continued) 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. amount exceeding the budget limit is held back by the Treasury and not transferred to the agencies specified in the appropriation bills. Dennis C. Plott (Notre Dame) & ECON 10020/20020 Spring / 72