Copyright 2011 by Pearson Education, Inc. Chapter 13 Fiscal Policy All rights reserved. Introduction Government expenditures on health care services have grown significantly since federal and state government began covering payments for various types of health-related expenses in the mid-1960s Today, government health care expenditures account for more than 30% of all federal government spending and as much as 35% of state government spending Do ongoing increases in government health care spending generate dollar-for-dollar increases in total planned expenditures in the U.S.? Do higher government health care expenditures displace a portion of private health care spending? Reading this chapter will help you answer these questions 13-2 Learning Objectives Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policy Discuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions Explain why the Ricardian equivalence theorem calls into question the usefulness of tax changes 13-3
Learning Objectives List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal fine tuning Describe how certain aspects of fiscal policy function as automatic stabilizers for the country 13-4 Chapter Outline Discretionary Fiscal Policy Possible Offsets to Fiscal Policy Discretionary Fiscal Policy in Practice: Coping with Time Lags Automatic Stabilizers What Do We Really Know About Fiscal Policy? 13-5 Did You Know That... When President Woodrow Wilson signed into law the U.S. federal income tax on October 1913, only about 1% of the U.S. population owed any income taxes? The Tax Foundation estimates that for $1 that households earning less than $24,000 per year pay in taxes, they get back transfers and services valued at $8.21 Every year, the government collects nearly $3 trillion in tax payments. The government spends $1.5 trillion more than this by borrowing the additional funds In this chapter, you will learn about how variations in taxes and government spending affect real GDP and the price level 13-6
Discretionary Fiscal Policy Fiscal Policy The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals, such as: High employment (low unemployment) Price stability Economic growth Improvement of international payments balance 13-7 Discretionary Fiscal Policy An increase in government spending will stimulate economic activity Changes in government spending Military spending Education spending Budgets for government agencies 13-8 Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a) If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand 13-9
Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b) If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand 13-10 Discretionary Fiscal Policy Questions Would the increase in government spending equal the size of the gap? What impact would expansionary fiscal policy have on the price level? 13-11 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E 1, where real GDP exceeds long-run equilibrium Contractionary fiscal policy can move aggregate demand to AD 2 via a tax increase A new equilibrium is at E 2 at a lower price level Real GDP is now consistent with LRAS 13-12
Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b) In panel (b) with a recessionary gap (in this case $500 billion) taxes are cut AD 1 moves to AD 2 The economy moves from E 1 to E 2, and real GDP is now at $12 trillion per year We are at the long-run equilibrium level 13-13 Discretionary Fiscal Policy Change in taxes A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports 13-14 Discretionary Fiscal Policy Question What would be the long-run impact of a tax cut on real GDP if the economy is at fullemployment equilibrium? 13-15
International Policy Example: Struggling to Boost Government Spending in Peru and in the United States In 2007, the president of Peru sought $1 billion in new expenditures on roads, drinking water facilities, and improvements to schools/ hospitals. Five months later, only $160 million of this had been spent Peru s system requires national government spending to be coordinated with regional governments, so the president had to coordinate with 23 new governors 13-16 International Policy Example: Struggling to Boost Government Spending in Peru and in the United States (cont d) Shortly after Barack Obama assumed the U.S. presidency in January 2009, Congress to authorize new spending aimed at heading off a worsening recession Five months later, the federal government had managed to disperse only about $31 billion of $300 billion in planned expenditures on roads, waterways, and schools As in Peru, discretionary spending was slowed by delays in the transmission of funds to the state governments responsible for maintaining U.S. roads, water resources, and schools 13-17 Possible Offsets to Fiscal Policy Fiscal policy does not operate in a vacuum and important questions must be answered How are expenditures financed and by whom? If taxes are increased what does government do with the taxes? What will happen if individuals worry about increases in future taxes? 13-18
Possible Offsets to Fiscal Policy Crowding-Out Effect The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates 13-19 Figure 13-3 The Crowding-Out Effect, Step by Step 13-20 Figure 13-4 The Crowding-Out Effect Due to crowding out, AD shifts inward to AD 3 13-21
Possible Offsets to Fiscal Policy Planning for the future: the Ricardian equivalence theorem Ricardian Equivalence Theorem The proposition that an increase in the government budget deficit has no effect on aggregate demand 13-22 Possible Offsets to Fiscal Policy Planning for the future: The Ricardian equivalence theorem The reason for the offset People anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly 13-23 Possible Offsets to Fiscal Policy Direct Expenditure Offsets Actions on the part of the private sector in spending income that offset government fiscal policy actions Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset 13-24
Policy Example: How U.S. States Created Direct Fiscal Offsets to Federal Spending In an effort to ward off the deepening Great Recession, the federal government transmitted nearly $50 billion to state governments during the latter half of its 2009 fiscal year However, rather than to direct the federal funds to additional spending, most state governments used the bulk of the funds to pay off debts generated by spending projects already in progress or even completed 13-25 Possible Offsets to Fiscal Policy The supply-side effects of changes in taxes Expansionary fiscal policy could involve reducing marginal tax rates Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more The increased productivity will lead to more economic growth 13-26 Possible Offsets to Fiscal Policy Supply-Side Economics The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward 13-27
Possible Offsets to Fiscal Policy Question Would a tax increase cause you to work more or less? 13-28 Figure 13-5 Laffer Curve Tax rates and tax revenues rise together Tax rates and tax revenues fall together 13-29 Policy Example: A Laffer Curve in the Mid-2000s? In 2003 Congress reduced the top tax rate on corporate dividends and the tax rate on capital gains along with cutting personal income tax rates slightly Many critics predicted that the federal government s tax revenues would plummet after these rates were cut 13-30
Policy Example: A Laffer Curve in the Mid-2000s? By the beginning of 2008, after 4 years of higher real GDP growth, total federal income tax receipts from corporations and individuals had increased by nearly 50% Why do you suppose it is difficult to determine exactly which factors are most responsible for the increase? 13-31 Discretionary Fiscal Policy in Practice: Coping with Time Lags Question Is fiscal policy as precise as it appears? 13-32 Discretionary Fiscal Policy in Practice: Coping with Time Lags Time lags Recognition Time Lag The time required to gather information about the current state of the economy 13-33
Discretionary Fiscal Policy in Practice: Coping with Time Lags Time lags Action Time Lag The time required between recognizing an economic problem and putting policy into effect Particularly long for fiscal policy which requires congressional approval 13-34 Discretionary Fiscal Policy in Practice: Coping with Time Lags Time lags Effect Time Lag The time it takes for a fiscal policy to affect the economy 13-35 Discretionary Fiscal Policy in Practice: Coping with Time Lags Fiscal policy time lags are: Long a policy designed to correct a recession may not produce results until the economy is experiencing inflation Variable in length they can be from 1-3 years, and the timing of the desired effect cannot be predicted Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy 13-36
Automatic Stabilizers Automatic or Built-In Stabilizers Changes in government spending and taxation that occur automatically without deliberate action of Congress The tax system Unemployment compensation Welfare spending 13-37 Automatic Stabilizers (cont d) The Tax System Incomes and profits fall when business activity slows down, and the government s tax revenues drop as well Some economists consider this an automatic tax cut, which therefore stimulates aggregate demand 13-38 Automatic Stabilizers (cont d) Unemployment Compensation and Income Transfer Payments Unemployment compensation reduces changes in people s disposable income. Their disposable income remains positive, although at a lower level In a recession, more people are eligible for income transfer payments and do not experience as dramatic a drop in disposable income 13-39
Automatic Stabilizers (cont d) Stabilizing Impact The key impact of these systems is the ability to mitigate changes in disposable income, consumption, and the equilibrium level of GDP If disposable income is prevented from falling as much as it otherwise would in a recession, the downturn will be moderated 13-40 Figure 13-6 Automatic Stabilizers The automatic changes tend to drive the economy back toward its fullemployment output level 13-41 What Do We Really Know About Fiscal Policy? Fiscal policy during normal times Congress ends up doing too little too late to help in a minor recession Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty 13-42
What Do We Really Know About Fiscal Policy? Fiscal policy during abnormal times Fiscal policy can be effective The Great Depression fiscal policy may be able to stimulate aggregate demand Wartime during World War II real GDP increased dramatically 13-43 What Do We Really Know About Fiscal Policy? The soothing effect of Keynesian fiscal policy Should we encounter a severe downturn, fiscal policy is available Knowing this may reassure consumers and investors Stable expectations encourage a smoothing of investment spending 13-44 Issues and Applications: Does Government Spending Crowd Out Private Health Care Expenditures? Medicare is a U.S. government health care program that covers many health care and pharmaceutical expenses incurred by elderly U.S. residents The nearly $500 billion per year that the government spends on Medicare is about 20 percent of combined public and private health care spending 13-45
Issues and Applications: Does Government Spending Crowd Out Private Health Care Expenditures? (cont d) In 1997, Congress created the jointly federal-and state-subsidized State Children s Health Insurance Program, which in most states pays the health care expenses of children in families with incomes as high as 350 percent of the official poverty income Recently, President Obama and Congressional leaders have pressed for further expansions of the federal government s health care spending 13-46 Issues and Applications: Does Government Spending Crowd Out Private Health Care Expenditures? (cont d) Considerable evidence suggests that government health care expenditures crowd out a significant amount of health care spending that otherwise would be undertaken from private funds 13-47 Summary Discussion of Learning Objectives The effects of discretionary fiscal policy using traditional Keynesian analysis Increases in government spending and decreases in taxes increase aggregate demand Decreases in government spending and increases in taxes decrease aggregate demand 13-48
Summary Discussion of Learning Objectives How indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions Deficits increase interest rates Some government spending replaces private spending If the Ricardian equivalence theorem is valid, a tax cut has no effect on total planned expenditures and aggregate demand 13-49 Summary Discussion of Learning Objectives Fiscal policy time lags and the effectiveness of fiscal fine tuning The time lags for fiscal policy are the recognition time lag, action time lag, and the effect time lag The time lags are long and variable Automatic stabilizers are changes in tax payments, unemployment compensation, and welfare payments that automatically change with the level of economic activity 13-50 Figure C-1 The Impact of Higher Government Spending on Aggregate Demand 13-51
Figure C-2 The Impact of Higher Taxes on Aggregate Demand 13-52