Fiscal Policy Part II

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1 Fiscal Policy Part II Much fiscal policy is implemented, not through spending increases, but through tax credits and other so-called tax expenditures. The markets should respond to them as they do spending cuts, with little contraction in economic activity. Alan Greenspan

2 Tax Cuts By lowering taxes, the government increases the disposable income of the private sector. Disposable income is the after-tax income of consumers; personal income less personal taxes.

3 Taxes and Consumption Tax cuts directly increase the disposable income of consumers. How much consumption increases depends on the marginal propensity to consume. initial increase in consumption = MPC x tax cut

4 Taxes and Consumption A dollar increase in tax cuts is less stimulative than a dollar increase in government purchases.

5 Taxes and Consumption An AD shortfall can be closed with a tax cut. desired tax cut = desired fiscal stimulus MPC

saving Second round of spending: Third round of spending: More consumption

6 Diagram: The Tax Cut Multiplier Tax Cut First round of spending: More consumption = MPC X tax cut More income More saving = MPS X tax cut More saving Second round of spending: Third round of spending: More consumption More income More consumption More saving Cumulative change in saving: = tax cut

7 Taxes and Investment A tax cut may also be an effective mechanism for increasing investment spending. Tax cuts have been used numerous times to stimulate the economy.

8 Increased Transfers Increasing transfer payments stimulates the economy. The initial fiscal stimulus (injection) of increased transfer payments is: initial fiscal stimulus = MPC x increase in transfer payments

9 Fiscal Restraint There are times when the economy is expanding too fast and fiscal restraint is more appropriate. Fiscal restraint is using tax hikes or spending cuts intended to reduce (shift) aggregate demand.

10 The Fiscal Target The AD excess is the amount by which aggregate demand must be reduced to achieve price stability after allowing for price-level changes. The AD excess exceeds the GDP gap.

11 The Fiscal Target The first task is to determine how much AD needs to fall: desired fiscal restraint = = desired AD reduction multiplier excess AD multiplier

12 Price Level (average price) Chart: Excess Aggregate Demand AS P E f E 1 P F E 2 Inflationary GDP gap AD 1 Excess AD AD 2 Q 2 = 5.8 Q F = 6.0 Q 1 = 6.2 Real Output (trillions of dollars per year)

13 Budget Cuts Budget cuts reduce government spending and induce cutbacks in consumer spending. cumulative reduction in spending = multiplier x initial budget cut

14 Tax Hikes Tax hikes can be used to shift the AD curve to the left. The direct effect of tax increases is a reduction in disposable income.

15 Tax Hikes Taxes must be increased more than a dollar to get a dollar of fiscal restraint. desired increase in taxes = desired fiscal restraint MPC

16 Reduced Transfers A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients. The desired reduction in transfers is the same as a desired tax increase.

17 Fiscal Guidelines The essence of fiscal policy is the deliberate shifting of the aggregate demand curve.

18 A Primer: Simple Rules The steps required to formulate fiscal policy are: Specify the amount of the desired AD shift. Select the policy tools needed to induce the desired shift.

19 Table: Fiscal Stimulus Desired fiscal stimulus AD the shortfall multiplier Policy Option Increase government purchases Cut taxes Increased transfers Amount desired fiscal stimulus desired fiscal stimulus MPC desired fiscal stimulus MPC

20 Table: Fiscal Restraint Desired fiscal restraint excess AD the multiplier Policy Option Reduce government purchases Increase taxes Reduce transfers Amount desired fiscal restraint desired fiscal restraint MPC desired fiscal restraint MPC

21 A Warning: Crowding Out Some of the intended fiscal stimulus may be offset by the crowding out of private investment expenditure. Crowding out is a reduction in private-sector borrowing (and spending) caused by increased government borrowing.

22 Time Lags It takes time to recognize that a problem exists and then formulate policy to address the problem. The very nature of macro problems can change if the economy is hit with other internal or external shocks.

They don t want spending cuts in their own districts.

23 Pork-Barrel Politics Members of Congress want their constituents to get the biggest tax savings. They don t want spending cuts in their own districts. They don t want a tax hike or spending cut before an election.

24 The End

INTRODUCTION FISCAL POLICY LEVERS TAXES AND SPENDING GOVERNMENT EXPENDITURE FISCAL POLICY PURCHASES VS. TRANSFERS

INTRODUCTION FISCAL POLICY LEVERS TAXES AND SPENDING GOVERNMENT EXPENDITURE FISCAL POLICY PURCHASES VS. TRANSFERS INTRODUCTION This chapter confronts the following questions: Chapter 11 FISCAL POLICY LEVERS Can government spending and tax policies help ensure full employment? What policy actions will help fight inflation?