• Fiscal policy - government changes levels of taxes (T) and/or government spending (G) to help the economy run at full employment
  • Promote economic growth (i.e. a growing real GDP)
  • Achieve low unemployment, etc.
  • Assume the money supply (MS) is fixed
    • Holding monetary policy constant
  • Council of Economic Advisors - three economists that advise the President about economics
• Government budget
  • Balanced budget: Government Revenue = Government Spending
    • Revenue - taxes, tariffs, and fees
    • Spending - military, social programs, etc.
    • T = G
  • Budget Deficit: Government Spending (G) > Government Tax Revenue (T)
    • Government debt grows by level of deficit
  • Budget Surplus: Government Revenue (T) > Government Spending (G)
    • Government debt falls
    • Government has extra money in its accounts
  • Budget deficit versus debt
    • Debt - total amount government owes
    • Budget deficit - amount G - T
      • Add the deficit to the debt
• From 1960-2008, the U.S. government had a deficit every year except 1960, 1969, 1998, 1999, 2000, and 2001
  • Why?
• Expansionary fiscal policy - government policy to cause the economy to expand
  • Lower taxes
  • Increase government spending
  • Aggregate Supply and Aggregate Demand are Shown below
    • Economy is in a recession and below Full Employment (FE)
      • Expansionary fiscal policy causes the AD function to shift right
      • Increase government spending
        • Degree of shift is the multiplier times the increase in G
      • Decrease taxes
        • Degree of shift is the tax time the multiplier times MPC
        • Households pay some taxes from savings
        • Decreasing taxes, increases disposable income
          • Households save and consume more
          • MPC is how much of a tax decrease expands the economy

• Contractionary fiscal policy
  • Government increases taxes
  • Government decreases government spending
  • Example - Economy is growing too rapidly; graph is below
    • Demand pull inflation
    • Contractionary fiscal policy causes AD function to shift left
    • Economy slows down and runs at Full Employment
    • Decrease government spending
      • Degree of shift is the multiplier times the decrease in G
    • Increase taxes
      • Degree of shift is the multiplier times the MPC and increase in T
      • Households pay the higher taxes from savings and lower consumption

• Index of Leading Economics Indicators
  • Index is not perfect, but gives a reasonable approximation how the economy is doing
  • If most indicators are negative, then economy may be in a recession
  • If most indicators are positive, then economy may be expanding
• Items
  1. Average workweek
  2. Initial claims for unemployment
  3. New orders for consumer goods
  4. Vendor performance
  5. New orders for captial goods
  6. Building permits for houses
  7. Stock prices
  8. Money Supply
  9. Interest rate spread - difference between short-term and long-term interest rates
  10. Consumer expectations

• Countercyclical impact
  • Slows down economy when economy is growing too fast
    • Helps increase a budget surplus (or lowers deficit)
  • Helps economy grow when economy is slowing down
  • Helps increase a budget deficit
  • Benefit - does not require government's action
• Automatic Stabilizers
  1. Unemployment compensation - unemployed workers receive temporary income from government
     • Recession - more workers are laid off and more people receive unemployment compensation
       • Government spending automatically increases
       • Government taxes automatically deceases
         • Firms bankrupt or reduce number of employed, so amount of taxes decreases
     • During an expansion - more worker are employed
       • Firms are created or hire more workers, so taxes increases
       • Government pays out fewer unemployment, so government spending decreases
  2. Corporate taxes - corporations pay taxes on their profits and investors pay taxes when they earn dividends
     • Recession - corporations earn smaller profits or losses, which reduces the amount of taxes paid
       • Example - 2008 Recession
       • New York State receives 25% of its income taxes from Wall Street
       • With many financial institutions bankrupting, New York State is expecting lower tax receipts
     • During an expansion - corporations pay more taxes as they earn more profits
  3. Progressive income tax system - households pay higher tax rates when their incomes are increasing
     • Recession - as households incomes fall, the average tax rate paid by families decrease
     • Business Expansion - as household incomes are rising, families are pushed into higher tax brackets.

Average tax rate = tax liability / taxable income.

        Example: Salary is $20,000 and tax liability is $5,000.

average tax rate = $5,000 / $20,000 X 100% = 25%

• Tax rates are classified into three types
  1. Progressive tax rate - average tax rate rises with income.
     • Example: U.S. Income taxes - low-income households pay small average tax rates, while high-income households pay higher tax rates.
  2. Proportional tax - the average tax rate stays the same across all income levels.
  3. Regressive tax - the average tax rate falls with income, i.e. higher income results in lower average tax rate.

Example: Sales tax on food. 2 families each spend $10,000 on food per year. Sales tax is 7%, so $700 is collected from each family per year.

    1st family's income = $50,000    F      1.4%
    2nd family's income = $20,000  F     3.5%

1. Time lags - causes problems when government tries to stimulate the economy

1. Recognition (or information) lag - takes time to collect data
   • Recession - two consecutive quarters of negative growth for real GDP
   • If government takes 3 months to collect data, then economy could already be in a recession
2. Administrative (or legislative) lag - government requires time to make a decision
   • Congress and the President have to agree to change taxes or increase levels of the U.S. debt
   • Congress and the President could agree quickly or take up to a year to implement a fiscal policy
3. Impact lag - takes time for the fiscal policy to impact the economy
   • Could be a from a six to twelve month delay for fiscal policy to impact economy

• Problem - time lags could make economy more unstable
  • Fiscal policy can take up to a year or more before impacting the economy
  • Some U.S. recessions were short-lived, lasting less than a year
    • An expansionary fiscal policy for a short lived recession could lead to more inflation
    • Once fiscal policy impacts the economy, the economy is already growing
      • Fiscal policy gives it a boost

2. Political Problems

1. Politicians want to be re-elected
   • They pass fiscal policies that are popular with the public before the election
     • Decrease taxes
     • Increase subsidies and transfer payments
   • Stimulates the economy before the election
     • Called a political business cycle
     • Usually voters vote out incumbents when economy is performing poorly
2. Political leaders may reverse fiscal policy or fiscal policy is temporary
   • A temporary fiscal policies may not impact the economy
   • Example - U.S. economy is entering a recession in 2008
   • President Bush approved an economic stimulus package
   • Each household gets between $300 and $600 boost on tax refunds
   • Bush wants households to spend this money, but households may end up saving it for the impending recession

3. State and local governments finance are pro-cyclical

• Pro-cyclical - taxes and spending reinforce the business cycle
  • State and local governments are required to operate balanced budgets
• Business cycle
  • Low unemployment and job creation create higher incomes
  • More tax revenue flows to state and local governments
  • Government pays less unemployment, welfare payments, etc, but increases spending in other areas
  • In turn, they increase their spending
  • Helps boost the economy
• Recession
  • High unemployment and job destruction
  • Less tax revenue flows to state and local governments
  • Government pays more unemployment, welfare payments, etc.
    • Boosts the economy
  • In turn, government raises taxes
    • Government almost never reduces its budget
    • Helps weaken the economy

4. Crowding Out Effect - government deficits and debt crowd out private investment

• Government deficit - government spending > taxes collected
  • Stimulates the economy's growth
  • Government borrows money from the public
  • Government competes with private companies for loans
  • If market has limited funds, a large budget deficit and debt can increase interest rates
    • Private sector borrows less money because interest rate is higher
  • U.S. government has never defaulted
    • Low risk
    • If in a financial crisis, government can increase taxes and/or "print" more money
    • Investors may invest in government because of lower risk
  • Thus, government deficits and debt can crowd out private investment
    • Problem - lower investment leads to lower growth
    • Problem - public sector may be expanding relative to the private sector
• Global Impact
  • High interest rates attract foreign investors
  • Causes currency to appreciate
    • Imports increase
    • Exports decrease
  • Thus, large deficits could reduce domestic production and encourage that country to import more

5. Laffer Curve - shows relationship between tax rates and tax revenues.

• Two points:
  • 0% tax rate = 0 tax revenue
  • 100 % tax rate = 0 tax revenue
• As the tax rate increases, the tax base decreases (the activity being taxed),
  • Tax changes behavior.
  • Deadweight loss increases.
• Example: The tax rate is 50% and the government wants to increase tax revenue.
  • If the tax rate is increased, tax revenue declines further.
  • If tax rate is lowered, then tax revenue increases!
  • Nobody knows the shape of these curves!!!
• Basis of Reaganomics.
  • Tax rates decreased, which caused tax revenue to increase.
  • During the 1980s, the average tax rates for the "rich" decreased.
  • Between 1980 and 1990 real income tax revenue collected from the top 1 % of earners rose a whopping 51.4 %.

Laffer Curve
Tax Revenue
Tax Rate

6. Current View of Fiscal Policy

• Before 1930s - economists believed government should not interfere with the economy
• During the Great Depression and by 1960s - economists believed government should use fiscal and monetary policy to influence the economy
  • Maynard Keynes - wrote and supported the use of fiscal policy
• After 1970s, the OPEC petroleum price increases and stagflation changed the view of economists
  • Macroeconomics breaksup into several schools of thought
    • Strong support for monetary policy
    • Disagreement on fiscal policy
  • I do not like fiscal policy
    • Government easily grows in size, but never contracts
    • Government is supposed to have budget surpluses during economic expansions
    • Instead, we have budget deficits during expansions and recessions

• Public Debt - total amount the U.S. government owes
  • Debt is the total amount of all deficits and minus budget surpluses
  • Reasons
    • Finance wars
    • Tax cuts
    • Lack of control by Congress and the President
• U.S. Treasury Securities (Loans)
  1. Treasury Bill - a security with a maturity less than a year
  2. Treasury Notes - a security with a maturity between 1 and 10 years
  3. Treasury Bonds - a security with a maturity exceeding 10 years
  4. U.S. Savings Bonds - long-term, non-marketable bonds
• Debt Statistics
  • Currently the debt is $10.1 trillion dollars(October 2008)
  • U.S. government agencies hold approximately 42% of the debt
    • Social Security surpluses are invested into the debt
    • U.S. government worker retirement accounts
    • Does not include Federal Reserve
  • Federal Reserve holds some of the debt
  • Foreigners hold about $1.8 trillion dollars or 18% (July 2008)
• U.S. debt relative to the economy is shown below
  • Absolute size of the debt is not relevant
  • It is how it compares to the economy

Comparing the United States to other countries

Debt to GDP Ratios for Several Countries
Country	Debt to GDP	Rank
Zimbabwe	211.90	1
Japan	195.50	2
Singapore	101.20	8
Canada	64.20	22
United States	60.80	27
Mexico	22.80	91

• Future Concern
  • Textbook - does not think debt is a problem
  • Problem
    • As the level of debt increases, the U.S. government pays interest on that debt
      • Interest is the third largest item on the debt
      • Interest becomes larger as debt becomes larger
      • Government cannot use this for the military, infrastructure, etc.
  • U.S. government goring bankrupt?
    • Not likely
    • Government is not like a business
      • Has the power to tax
      • Has the power to print money
      • Government can refinance the debt
        • As old debt matures, the U.S. Treasury issues new debt
  • Burdening Future Generation
    • Future generations inherit this debt
    • Government can reshuffle debt to reduce the burden future generation
    • Future generation may not get the same level of government benefits
      • Interest becomes a larger budget item
    • However, government will have to start paying out of social security in 2020
      • Social Security is no longer free money
      • Government will have to lower benefits or reduce other government programs
        • Government spent the Social Security Surplus and put U.S. Treasuries in its place
  • Future Economic Impact
    • Economy may not perform well
      • Government is crowding out investment
        • Economy grows less from less capital stock
      • Foreigners earn interest on debt
        • Income will be flowing outside the country
      • If governmetn imposes higher taxes, a highly-taxed society grows less
      • Worse case scenario is government prints money to cover a deficit
        • Leads to high inflation rates

Ronald Reagan - "If it moves, tax it! If it keeps moving, regulate it! If it stopped moving, subsidize it!"