The big picture marcoeconomics 12e parkin chapter 13

Supply-Side Effects of Fiscal Policy The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects..  An income tax decreases the supp

T h e B i g P i c t u r e

Where we have been:

This chapter extensively uses the aggregate supply-aggregate demand model introduced in Chapter 10 It also makes use of Chapter 11’s discussion of multipliers The material on the labor market and potential GDP from Chapter

6 is important when discussing the supply-side effects of fiscal policy

Where we are going:

Chapter 14 on monetary policy completes the material on macroeconomic stabilization policies

N e w i n t h e Tw e l f t h E d i t i o n

This chapter is rich with data, which has all been updated to 2014 The At Issue section has updated content while it continues to have President Obama and Paul Ryan’s contrasting policy suggestions The Economics in the News feature at the end of the chapter discusses a 2014 article on Japan’s challenges with its debt and deficit The Worked Problem explores the short-run and long-run consequences on economic growth and other variables of an increase in infrastructural expenditure

and a decrease in taxes The AD-SAS model is used to answer the questions To

include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These

problems are still in the MyEconLab and are called Extra Problems

C h a p t e r

19

Fiscal Policy

 Fiscal policy refers to changes in government expenditure and taxes

 Fiscal policy impacts both aggregate supply and aggregate demand

I The Federal Budget

The annual statement of the outlays and receipts of the government of the United States together with the laws and regulations that approve and support those outlays and receipts

make up the federal budget The use of the federal budget to achieve macroeconomic

objectives such as full employment, sustained economic growth, and price level stability is

called fiscal policy.

The Institutions and Laws

 The President submits a budget proposal to Congress Congress debates, amends, and enacts the budget The budget operates within the framework of the

Employment Act of 1946, which states: “… 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.”

 The Council of Economic Advisers monitors the economy and keeps the President

and the public well informed about the current state of the economy and the best available forecasts of where it is heading

Highlights of the 2015 Budget

 Receipts come from four sources: personal income taxes ($1,505 billion), social security taxes ($1,176 billion), corporate income taxes ($537 billion), and indirect taxes and other receipts ($296 billion)

 Outlays are classified in three categories: transfer payments ($2,649 billion),

expenditure on goods and services ($1,030 billion), and debt interest ($479 billion)

 Budget balance = Receipts – Outlays

 If receipts 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 U.S Budget in Historical Perspective and in Global Perspective

 Since 1990, except between 1998 to 2001, the U.S government has had a budget deficit

 Government debt is the total amount that the government has borrowed A

budget deficit adds to the government debt

 In 2014, all of the world’s major economies except Germany had a budget deficit The newly industrialized economies of Asia had the smallest deficits while Japan, the United States, the United Kingdom (in that order) had the largest deficits as a

fraction of GDP The U.S deficit was about 5 percent of GDP

The At Issue detail presents arguments about different budget plans President Obama’s plan keeps the budget deficit constant at $500 billion through 2024, while Representative Paul Ryan’s plan would slash the deficit to $100 billion over the same time period

Deficit and debt Many students need help with the distinction between the deficit and

the debt (and with what happens to the debt when there is a surplus) Use the student loan

or credit card analogy Explain that the budget balance (the deficit or surplus) is just like a personal budget balance (the amount that a student borrows or pays back during a given year) The debt—the total amount owed by the government—is like the balance on a

student loan or credit card account Students (usually) have a budget deficit and

increasing debt And graduates with a job (usually) have a budget surplus and decreasing debt

An interesting historical episode During the mid-1830s—a long time ago—the U.S

government had virtually repaid all its debt At that time the government faced a problem that doesn’t occur today: it had a surplus and didn’t know what to do with it The decision

was made to transfer money to the state governments Each state was to receive $400,000

in four payments of $100,000 each The first three payments were made, but the last one

was postponed because of a recession in 1837 that lowered the federal government’s

revenue and then was never made In the 1970s, faced with a severe budget crunch, the

State of New York sued to receive that last payment plus interest The state lost the suit

and so the last payment probably will never be made! (You might remark that $100,000

invested in 1837 at the average interest rate would have accumulated to about $30 billion

by 2015!)

II Supply-Side Effects of Fiscal Policy

The effects of fiscal policy on employment, potential GDP, and aggregate supply are known

as supply-side effects.

The Effects of Taxes on Full Employment and

Potential GDP

 The labor market determines the full

employment quantity of labor, which,

together with the production function,

determine potential GDP

 The equilibrium quantity of employment is

determined in the labor market The first

figure shows the labor market In the figure

equilibrium employment is 250 billion hours

per year This amount of employment is

full-employment

 The second figure shows the production

function With employment of 250 billion

hours, the production function shows that

real GDP is $13 trillion

 An income tax decreases the supply of labor and shifts the supply of labor curve

leftward In the top figure, the LS curve shifts leftward Because of the tax wedge, the level of employment decreases In the bottom figure the decrease in employment

decreases potential GDP

 An income tax drives a tax wedge

between the before-tax wage rate that firms

pay and the after-tax wage rate that

workers receive Other taxes, such as sales

taxes, add to the tax wedge by effectively

lowering the real wage rate

Some Real World Tax Wedges … Does the Tax

Wedge Matter?

Tax wedges vary across countries, being much

higher in France than in the United States

According to supply-side economists such as Ed

Prescott, the tax wedge has a large impact on

potential GDP Potential GDP per person in France is 30 percent below that in the United States and Prescott asserts that the entire difference can be attributed to the difference in the countries’ tax wedges

Taxes and the Incentive to Save and Invest

 A tax on interest income decreases the

supply of saving and shifts the supply of

loanable funds curve leftward The tax

drives a wedge between the after-tax

interest rate received by savers and the

interest rate paid by firms The tax does not

change the demand for loanable funds

The figure shows the result: the real

interest rate paid by borrowers rises (from

5 percent to 6 percent in the figure) and

the equilibrium quantity of loanable funds

and investment decrease

 The decrease in investment lowers the

growth rate of potential GDP

Tax Revenues and the Laffer Curve

 The relationship between the tax rate and the amount of tax collected is called the

Laffer curve The Laffer curve shows that at a high enough tax rate, an increase in

tax rates decreases tax revenues Tax revenues decrease because individuals find

ways to avoid the high taxes, including by working less

 Most economists believe that taxes have an effect on the supply of labor, but that in the U.S economy, the tax rate is low enough so that an increase in the tax rate

increases tax revenues

Laffer Curve and Napkins: Students get a kick out of the napkin roots of the Laffer

Curve The story that Laffer himself cannot deny nor confirm is that he first drew the Laffer curve on a napkin during one of his first attempts to persuade someone of his supply side

theory Draw the Laffer curve and ask what side of the curve are we on? Ask them what

they think the highest tax rate was in the United States, they are usually shocked to learn

that we had marginal rates in the 70% range as recently as the 1970 This a great

discussion point on how high tax rates can deter work!

Consumption Tax: Students enjoy exploring the controversial idea of abolishing the IRS in

favor of a consumption tax Whether you agree with it or not, the Fairtax plan (Google

Fairtax plan to find the website) covers many issues from this chapter and is an awesome

way to bring together many of the topics from the course Students engage with the

concept of a revenue neutral switch from our mixed tax system to 100% consumption tax I assign a short paper for them to investigate one of the many sub-topics within the plan

The Economics in the News detail compares the U.S corporate tax rate with those in other countries and explores how the tax wedge affects the U.S loanable funds market

III Generational Effects of Fiscal Policy

Generational accounting is an accounting system that measures the lifetime tax burden

and benefits of government programs to each generation

Generational Accounting and Present Value

To compare the costs and benefits that occur at different points in the future, which is

necessary in generational accounting, the concept of present value is used A present value

is an amount of money that, if invested today, will grow to equal a given future amount

when the interest that it earns is taken into account Because there is uncertainty about the

proper interest rate to use when calculating present values, plausible alternative numbers are used to estimate a range of present values

The Social Security Time Bomb

 Fiscal imbalance is the present value of the government’s commitments to pay

benefits minus the present value of its tax revenues In 2014, the fiscal imbalance was estimated to be $68 trillion and growing by about $2 trillion every year The fiscal imbalance is high because of obligations under Social Security laws and Medicare

 There are four alternatives for redressing the fiscal imbalance: raise income taxes, raise Social Security taxes, cut Social Security benefits, or cut federal government discretionary spending But the changes needed would be severe It is estimated that income taxes would need to be raised by 69 percent; or Social Security taxes raised by 95 percent; or Social Security benefits cut by 56 percent

Generational Imbalance

Generational imbalance is the division of the fiscal imbalance between the current and

future generations assuming that the current generation will enjoy the current levels of taxes and benefits It is estimated that the current generation will pay 83 percent of the fiscal imbalance and the future generations will pay 17 percent

IV Fiscal Stimulus

 A fiscal action that is initiated by an act of Congress is called discretionary fiscal policy.

 A fiscal action that is triggered by the state of the economy is called automatic fiscal policy.

Automatic Fiscal Policy and Cyclical and Structural Budget Balances

 Tax revenues and needs-tested spending change with the business cycle

 The government sets tax rates As incomes vary with the business cycle, the tax revenue collected changes Tax revenue automatically falls in recessions and automatically rises in expansions

 Government expenditure on programs that pay benefits to people and

businesses depending on their economic status is called needs-tested

spending Needs-tested spending automatically increases in a recession and

automatically decreases in an expansion, helping to stabilize the economy

 Induced taxes and needs-tested spending mean that the federal budget deficit is counter-cyclical, with the deficit increasing in a recession and decreasing in an expansion

 The structural surplus or deficit is the budget balance that would occur if the

economy were at full employment and real GDP were equal to potential GDP The

cyclical surplus or deficit is the actual surplus or deficit minus the structural

surplus or deficit

 In 2014 the total U.S budget deficit was $0.64 trillion According to the

Congressional Budget Office (CBO) the cyclical deficit was $0.18 trillion so the structural deficit was $0.46 trillion

 The structural deficit skyrocketed after 2008

By their nature, automatic fiscal policy implies federal budget deficits in recessions as tax revenues fall and spending increases By contrast, balanced budget rules for state and local governments mean that these governments do not conduct stabilizing fiscal policy In the 2008 recession, the sharp decline in state and local tax revenues meant that state spending programs had to be cut and, in some states, taxes raised Such policies are the opposite of the policies that can be used to help stabilize the business cycle

 Automatic fiscal policy helps stabilize the business cycle because it provides an

automatic stimulus during a recession and an automatic contraction during an

expansion

Discretionary Fiscal Stimulus

 The government expenditure multiplier is the quantitative effect of a change in

government expenditure on real GDP An increase in government expenditure

increases aggregate expenditures setting in motion the multiplier process

 The tax multiplier is the quantitative effect of a change in taxes on real GDP A

decrease in taxes increases disposable income and hence consumption expenditure, setting in motion the multiplier process

 The effect on aggregate demand from a tax cut is less than that from a similar

sized increase in government expenditure A $1 tax cut generates less than a $1

increase in consumption expenditure since only a fraction (equal to the MPC) of

the $1 increase in disposable income is spent on consumption expenditure

Fiscal Stimulus

 Expansionary fiscal policy (an increase in

government expenditure or a decrease in

taxes) seeks to eliminate a recessionary

gap If timed correctly and of the correct

magnitude, fiscal policy can be used to

push the economy to potential GDP

 The figure shows the effect of expansionary

fiscal policy on aggregate demand At the

initial equilibrium, $15 trillion real GDP and

price level of 110, there is a recessionary

gap The expansionary policy increases

aggregate demand and the multiplied

effect shifts the AD curve rightward from

AD0 to AD1 The recessionary gap is

eliminated and the economy moves to its

new equilibrium, $16 trillion real GDP

(which equals potential GDP) and price level of 115

Fiscal Stimulus and Aggregate Supply

The focus so far has been on only aggregate demand But fiscal policy also impacts

aggregate supply

 Government Expenditure: An increase in government expenditure increases the budget deficit The demand for loanable funds increases, so the real interest rate rises and investment is crowded out The decrease in investment offsets the

expansionary effect from the increase in government expenditure The crowding-out effect is strong enough so that the government expenditure is less than 1

 Tax Cut: A tax cut also has effects on aggregate supply A tax cut increases the supply of labor and the supply of loanable funds, both of which increase aggregate supply The supply-side effects make the tax multiplier larger than the government expenditure multiplier

There is quite a bit of controversy about the size of the multipliers and this controversy is nicely covered in an Economics in Action detail Christina Romer, while working for the Obama administration, asserted that the government expenditure multiplier was 1.5 Robert Barro, of Harvard University, says his research shows the multiplier is 0.5 These differences are dramatic and students can appreciate their importance and real-world relevance Highlight the Ricardo-Barro effect as a possible argument for smaller

multipliers

Limitations of Discretionary Fiscal Policy

In practice, discretionary fiscal policy is hampered by three time lags:

 Recognition Lag: The recognition lag is the time it takes to figure out that fiscal policy actions are needed

 Law-Making Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending

 Impact Lag: The impact lag is the time it takes from passing a tax or spending

change to implementing the new arrangements and feeling their effects on real GDP

Fiscal policy in practice Most economists acknowledge that, in principle, discretionary

fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags It is worth reminding the students that

the equilibrium in the AS-AD model takes time to work out The multiplier is a long drawn

out process An increase in government expenditure shifts the AD curve rightward but the

new equilibrium price level and real GDP take time to occur It is also useful to discuss the

length of time it took the Congress to pass the 2002 “stimulus package” and the time it

took in the Fall of 2008 to decide on a fiscal policy to be used after the initial “bailout

package.” The law-making lag can be substantial and the outcomes questionable!

A d d i t i o n a l P r o b l e m s

1 The government is proposing to lower the tax rate on labor income and asks you to report on the supply-side effects of such an action Answer the

following questions and describe what happens on the relevant graph You are being asked about directions of change, not exact magnitudes

a What will happen to the supply of labor and why?

b What will happen to the demand for labor and why?

c What will happen to the equilibrium level of employment and why?

d What will happen to the equilibrium before-tax wage rate?

e What will happen to the equilibrium after-tax wage rate?

f What will happen to potential GDP?

2 How Reagan Would Fix the Economy

Many Republicans look at Reagan’s policies in the early 1980s and assert that tax cuts pay for themselves That’s wrong—Reagan’s rate cuts for the rich paid for themselves, but the tax cuts for the poor, the middle class and

corporations did not The deficit increased But there is a limit to the deficit

At some time the government debt grows so large that it starts to harm the economy through higher interest rates, bigger debt payments, a weaker currency, etc

Time, May 26, 2008

a Explain why Reagan’s tax rate cuts for high income taxpayers may have paid for themselves, but cuts for lower-income and middle-income taxpayers did not

b Explain the negative consequences of running persistently large budget deficits

3 Explain why extending unemployment insurance benefits has both a supply-side and demand-supply-side effect on real GDP and the price level

S o l u t i o n s t o A d d i t i o n a l P r o b l e m s

1 a The supply of labor increases The supply of labor curve shifts rightward The supply

of labor increases because at each real wage rate, the after-tax wage rate received

by workers will be higher given a decrease in the tax rate on labor income

b The demand for labor remains the same The demand for labor depends on the productivity of labor, which remains the same following the decrease in the tax rate

on labor income

c The equilibrium level of employment increases With the rightward shift in the supply

of labor curve, the real wage rate decreases and the quantity of labor demanded increases along the demand for labor curve Equilibrium employment increases

d The equilibrium pre-tax wage rate decreases The rightward shift of the supply of labor curve leads to movement down along the demand for labor curve

e The equilibrium after-tax wage rate increases The decrease in the tax rate on labor income decreases the wedge between the before-tax wage rate and the after-tax wage rate The before-tax wage rate decreases but not by as much as the decrease

in tax So the after-tax wage rate increases