Answers to review quizzes marcroeconomics 12e parkin chapter 13

Taxes, such as income taxes, and needs-tested spending programs both work as automatic fiscal policy because they decrease the effect a change in income has on aggregate expenditure.. Fi

A n s w e r s t o t h e R e v i e w Q u i z z e s

Page 366 (page 774 in Economics)

1 What is fiscal policy, who makes it, and what is it designed to influence?

Fiscal policy is the use of the federal budget to achieve macroeconomic objectives Fiscal policy is made by the president and Congress It is designed to influence employment, economic growth, and price level stability

2 What special role does the president play in creating fiscal policy?

Each year the president proposes the budget that Congress amends and enacts

3 What special roles do the Budget Committees of the House of

Representatives and the Senate play in creating fiscal policy?

Each year the Budget Committees of the House of Representatives and the Senate consider the budget proposed by the president, and develop their own ideas of how

it should be modified Eventually, formal conferences between the two houses resolve the differences between them and a series of spending acts and an overall budget act passed

4 What is the timeline for the U.S federal budget each year? When does a fiscal year begin and end?

Consider the budget for 2015 as an example in answering this question In

February 2014 the president proposes a budget to Congress Then, from February until October 1, 2014, the Congress debates the budget, amends it, and eventually passes the necessary budget bills The president then signs or vetoes the budget bills that were presented to him When the president vetoes bills, the Congress may over-ride the veto or pass other bills acceptable to the president Fiscal year

2015 begins on October 1, 2014 and runs until September 30, 2015 During this year the Congress may pass—and the president may sign—supplementary bills Then, after the fiscal year ends, accounts are prepared and the “official” amounts

of outlays, receipts, and budget deficit or surplus are reported

5 Is the federal government budget today in surplus or deficit?

Currently, the U.S federal government is running a (large) budget deficit

1 3

207

Page 371 (page 779 in Economics)

1 How does a tax on labor income influence the equilibrium quantity of

employment?

A tax on labor income drives a wedge between the after-tax wage rate of workers and the before-tax wage rate paid by firms The tax on labor income decreases the supply of labor That is, for each before-tax wage rate, workers provide a lower quantity of labor when faced with a tax that lowers their after-tax wage The decrease in labor supply raises the before-tax wage rate, even though the after-tax wage rate received by workers falls The decrease in labor supply also means that the quantity of employment at full employment (i.e., equilibrium employment in the labor market) falls

208

3 Why are consumption taxes relevant for measuring the tax wedge?

A tax on consumption raises the price paid for consumption goods and services and so is equivalent to a cut in the real wage rate from the perspective of workers

4 Why are income taxes on capital income more powerful than those on labor income?

Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans In particular, by driving a wedge between the real interest rate savers receive and firms pay, the tax on interest income decreases the supply of loanable funds, which lowers investment and saving in the economy

5 What is the Laffer curve and why is it unlikely that the United States is on the

“wrong” side of it?

The Laffer curve is the relationship between the tax rate and the amount of tax revenue collected The amount of tax revenue collected increases with the tax rate only up to a certain tax rate, after which, further increases in the tax rate cause tax revenue to fall When tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on the wrong side of the Laffer curve It is unlikely that the United States is on the wrong side of the Laffer curve because U.S tax rates are among the lowest in the industrial world and past changes in U.S tax rates have produced changes in tax revenues in the same direction

Page 374 (page 782 in Economics)

1 What is a present value?

A present value is the 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

2 Distinguish between fiscal imbalance and generational imbalance

Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues Generational imbalance is the division of the fiscal imbalance between the current and future generations,

assuming that the current generation continues to enjoy the current levels of taxes and benefits

3 How large was the estimated U.S fiscal imbalance in 2014 and how did it divide between current and future generations?

In 2014, the fiscal imbalance was estimated to be $68 trillion The generational imbalance estimates suggest that the current generation will pay 83 percent and future generations will pay 17 percent of the fiscal imbalance

4 What is the source of the U.S fiscal imbalance and what are the painful

choices that we face?

The source of the fiscal imbalance is the social security and, especially, the

Medicare obligations made under current law The painful choices are to raise income taxes, raise social security taxes, cut social security benefits, or cut federal government discretionary spending

5 How much of U.S government debt is held by the rest of the world?

U.S government debt held by the rest of the world is about $5.8 trillion

Page 379 (page 787 in Economics)

1 What is the distinction between automatic and discretionary fiscal policy?

Automatic fiscal policy is triggered by the state of the economy with no need for

any government action Discretionary fiscal policy, however, requires an act of

Congress to either change government spending and/or change taxes

2 How do taxes and needs-tested spending programs work as automatic fiscal policy to dampen the business cycle?

Taxes, such as income taxes, and needs-tested spending programs both work as

automatic fiscal policy because they decrease the effect a change in income has

on aggregate expenditure For instance, when income decreases, consumption

expenditure and aggregate expenditure decrease But with the fall in income,

income taxes decrease and needs-tested spending increase so that disposable

income does not fall as much as does income The smaller fall in disposable

income means that the fall in consumption expenditure is smaller, so that the fall

in aggregate expenditure is likewise smaller

3 How do we tell whether a budget deficit needs discretionary action to remove it?

A budget deficit needs discretionary government action to remove it when the

deficit is a structural deficit If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain However, if the deficit is a

cyclical deficit, then when the economy returns to full employment, the deficit will disappear

4 How can the federal government use discretionary fiscal policy to stimulate

the economy?

If the economy has a recessionary gap, the government can increase its

expenditure or lower taxes to increase aggregate demand and move the economy back toward potential GDP

5 Why might fiscal stimulus crowd out investment?

Fiscal stimulus, such as an increase in government expenditure or a decrease in

taxes, increases the budget deficit The increase in the budget deficit increases the (government’s) demand for loanable funds, thereby raising the real interest The

higher real interest rate decreases—crowds out—investment

A n s w e r s t o t h e S t u d y P l a n P r o b l e m s a n d

A p p l i c a t i o n s

Use the following news clip to work Problems 1 and 2

Economy Needs Treatment

It’s the debt, stupid! Only when the government sets out a credible business plan will confidence and hiring rebound

Source: The Wall Street Journal, October 7, 2010

1 How has the U.S government debt changed since 2008? What are the

sources of the change in U.S government debt?

Since 2008 the U.S government debt has skyrocketed The debt dramatically rose because federal government taxes fell (as a percent of GDP) while federal

government expenditures and transfer payments, shot upwards Federal

government expenditures on goods and services rose but not nearly as much as transfer payments

2 What would be a “credible business plan” for the government to adopt?

A “credible business plan” would be a plan for the government that shrinks the deficit and thereby stops the rapid increase in the government debt This plan likely would involve cutting government outlays and increasing government

receipts

3 The government is considering raising the tax rate on labor income Explain the supply-side effects of such an action and use appropriate graphs to show

the directions of change, not exact magnitudes What will happen to:

a The supply of labor and why?

The supply of labor will decrease As

shown in Figure 13.1, the supply of labor

curve shifts leftward from LS0 to LS1 The

supply of labor decreases because at

each real wage rate, the hike in the tax

rate on labor income lowers the after-tax

wage rate received by workers

b The demand for labor and why?

The demand for labor will remain the

same so in Figure 13.1 the demand for

labor curve remains LD The demand for

labor depends on the productivity of

labor, which does not change after the

increase in the tax rate on labor income

c Equilibrium employment and why?

As Figure 13.1 shows, the equilibrium

level of employment decreases In the

figure, employment decreases from 310 billion hours per year to 300 billion hours per year

d The equilibrium before-tax wage rate and why?

As Figure 13.1 shows, the equilibrium before-tax wage rate increases from $34 per hour to $35 per hour The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to a movement up along the demand for labor curve

e The equilibrium after-tax wage rate and why?

The equilibrium after-tax wage rate decreases The tax wedge in the figure is $2

per hour, so the after-tax wage rate falls from $34 per hour to $33 per hour The

increase in the tax rate on labor income increases the wedge between the

before-tax wage rate and the after-before-tax wage rate The before-before-tax wage rate increases but not by as much as the increase in tax So the after-tax wage rate decreases

f Potential GDP?

Potential GDP decreases The equilibrium

level of employment is full employment

So as full employment decreases,

potential GDP decreases along the

aggregate production function Figure

13.2 shows this change as the

movement along the aggregate

production function, PF, from point A,

with 310 billion hours of employment

and potential GDP of $16.2 trillion, to

point B, with 300 billion hours of

employment and potential GDP $16.1

trillion

4 What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work

A decrease in the tax on capital income will increase investment and thereby increase economic growth A decrease in the tax on capital income increases the supply of loanable funds The real interest rate falls and investment increases The increase in investment increases economic growth

5 Suppose that instead of taxing nominal capital income, the government taxed

real capital income Use appropriate graphs to explain and illustrate the effect

that this change would have on:

a The tax rate on capital income

The nominal interest rate is the (nominal) income from capital If the government changes the tax code to subtract the inflation rate from the (nominal) interest rate before taxes are imposed, the true tax

rate on capital income falls because the

part of the capital income—the inflation

rate—that is received in compensation

for inflation is no longer taxed

b The supply of and demand for

loanable funds

With a lower tax rate on capital income,

the supply of loanable funds increases

as the after-tax real interest rate rises

This change is illustrated in Figure 13.3

by the rightward shift of the supply of

loanable funds curve from the initial

supply of loanable funds curve, SLF0, to

SLF1

The demand for loanable funds

generally remains the same because it

depends in large part on investment demand Firms’ investment demand depends

on how productive capital is and the productivity of capital does not necessarily

change when the tax code changes In Figure 13.3, the demand for loanable funds curve does not shift

c Investment and the real interest rate

As shown in Figure 13.3, the increase in the supply of loanable funds shifts the

supply of loanable funds curve rightward This change leads to a lower real

interest rate and a higher amount of loanable funds and investment

6 Under current policies, a plausible projection is that U.S public debt will reach

250 percent of GDP in 30 years and 500 percent in 50 years

a What is a fiscal imbalance? How might the U.S government reduce the fiscal imbalance?

The fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues To reduce the fiscal

imbalance, the government needs to decrease its benefit payments—both its

present payments and those promised in the future—and increase its tax revenue

—both its current tax revenue and tax revenue in the future While the annual

government budget deficit is not the fiscal imbalance, it is related because, in

general, the larger the budget deficit the larger the fiscal imbalance Additionally, the larger the budget deficit, the larger the accumulated public debt becomes

b How would your answer to part (a) influence the generational imbalance?

The generational imbalance is the division of the fiscal imbalance between the

current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits The changes in part (a) of cutting benefits

and raising taxes will affect the generational imbalance if the reduction in benefits and/or the hike in taxes affects the current generation In that case the

generational imbalance would change so that more of the fiscal imbalance is paid

by the current generation and less by future generations

7 The economy is in a recession, and the recessionary gap is large

a Describe the discretionary and automatic fiscal policy actions that might

occur

Fiscal policy that increases government expenditure or decreases taxes would

boost aggregate demand In terms of automatic fiscal policy, needs-tested

spending increases in recessions and tax revenue falls Congress might also use

discretionary policy by passing a new spending bill or a cut in tax rates

b Describe a discretionary fiscal stimulation package that could be used that

would not bring an increase in the budget deficit.

An increase in government expenditure with an offsetting increase in tax rates to

boost tax revenue would not bring a budget deficit and would increase aggregate demand because the increase in government expenditure increases aggregate

demand by more than the increase in taxes decreases aggregate demand

c Explain the risks of discretionary fiscal policy in this situation

The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP

8 An economy is in a recession with a large recessionary gap and a government budget deficit

a Do we know whether the budget deficit is a structural deficit or a cyclical

deficit? Explain

We know that at least some of the budget deficit in a recession is a cyclical deficit

as needs-tested spending is higher and tax revenue is lower than at potential GDP

However, some of the budget deficit might be a structural deficit The structural deficit is the deficit that would exist if real GDP equaled potential GDP and the economy was at full employment

b Explain how automatic fiscal policy is changing the output gap?

Automatic fiscal policy is decreasing the output gap relative to what it would be otherwise in a recession because they increase aggregate demand relative to what

it would be otherwise in a recession That is, aggregate demand decreases in a recession, but it would decrease by more without the increase in needs-tested spending and the decrease in tax revenue that produce the cyclical deficit

c If the government increases its discretionary expenditure, explain how the structural deficit might change

A discretionary increase in government expenditure, if not reversed following the end of the recession, moves the budget balance toward a structural deficit

Use the following news clip and fact to work Problems 9 to 11

Senate Approves Obama Tax Cut Plan

The U.S Senate has passed legislation extending Bush-era tax cuts for

high-income earners to middle-class Americans earning up to $250,000 per year

Source: Financial Times, July 26, 2012

Fact: Middle and low-income earners spend almost all their disposable incomes

High-income earners save a significant part of their disposable incomes

9 a Explain the intended effect of

extending tax cuts for middle-class

Americans but not for high-income

families Draw a graph to illustrate

the intended effect

The goal of extending the tax cuts for

middle-class Americans has an

intended effect of increasing

consumption expenditure, which

increases aggregate demand Figure

13.4 shows the intended effect of this

policy where, including the multiplier

effect, the aggregate demand curve

shifts rightward from AD0 to AD1 As a

result real GDP increases, in the figure

from $15.7 trillion to $15.9 trillion In

the figure real GDP remains below

potential GDP but the recessionary gap

becomes smaller

b Explain why the effect of tax cuts depends on who receives them

The effect of this fiscal policy depends on the size of the impact on aggregate demand The more of the tax cut that is spent (which means the less that is saved) the larger the magnitude of the effect on aggregate demand If the tax rebates go

to people who spend more of the rebate, that is, middle and low-income earners, the effect of this fiscal policy is larger

10 What would have a larger effect on aggregate demand: extending the Bush-era tax cuts to everyone; extending them for middle-class only; or extending them for high-income earners only? How would each alternative compare with

no tax cuts but an equivalent increase in government expenditure?

Extending the income tax cuts to everyone will have the largest effect on

aggregate demand Middle-income tax payers will spend most of the tax cut and

high-income tax payers, while spending only a small fraction of their income, still spend some In general, tax cuts have a larger effect on real GDP than do

increases in government expenditure because the tax cuts have stronger

supply-side effects So whichever tax cut policy—extending the tax cuts to everyone, to

only middle-class taxpayers, or to only high-income tax payers—has the largest

supply-side effect also has the largest effect on real GDP

11 Compare the impact on equilibrium real GDP of a same-sized decrease in

taxes and increase in government expenditure on goods and services

According to the aggregate demand/aggregate supply model, the government

expenditure multiplier exceeds the tax multiplier, so government expenditure has

a larger impact on real GDP Some economists, such as Robert Barro and Harald

Uhlig disagree and assert that the tax multiplier exceeds the government

expenditure multiplier because taxes affect aggregate demand and aggregate

supply In this case the decrease in taxes has a larger impact on real GDP