Macro ch 11

How much would a person with an income of $6,500 pay in taxes?

$680 To determine the amount the person has to pay in taxes, you should have made the following calculation: $500+($6,500−$5,000)×0.12=$680$500+$6,500−$5,000×0.12=$680. See Section: Government Tax Revenues.

Complete Crowding Out

A decrease in one or more components of private spending that completely offsets the increase in government spending.

Incomplete Crowding Out

A decrease in one or more components of private spending that only partially offsets the increase in government spending.

According to demand-side economists, the increase in income taxes decreases disposable income, leading to a decrease in consumption and a leftward shift of the AD curve. The increase in income taxes decreases Real GDP, decreases employment, and decreases the price level.

According to supply-side economists, the increase in income taxes decreases after-tax income, giving workers a weaker incentive to work. In so doing, the increase in income taxes shifts the supply of labor curve to the left, causing wages to increase. This leads to a leftward shift of the AS curve. According to supply-siders, the increase in income taxes will decrease Real GDP, decrease employment, and increase the price level

Suppose the economy had been producing at Natural Real GDP but is now experiencing a recession. Which of the following are discretionary fiscal policies that could bring the economy closer to Natural Real GDP?

Additional spending on national park facilities, A tax cut If the economy is experiencing a recession, then output is less than Natural Real GDP. The result is a recessionary gap. To stimulate aggregate demand and move the economy toward Natural Real GDP, policymakers could implement a discretionary fiscal policy, such as cutting taxes or increasing government spending on national parks. A tax increase and a reduction in spending on education would have the reverse effect, because they would decrease aggregate demand.

regressive income tax

An income tax system in which a person's tax rate declines as his or her taxable income rises.

proportional income tax

An income tax system in which a person's tax rate is the same regardless of taxable income.

progressive income tax

An income tax system in which one's tax rate rises as taxable income rises (up to some point).

balanced budget

Budget in which revenues are equal to spending

Fiscal policy

Changes in government expenditures and/or taxes aimed at achieving economic goals, such as low unemployment, stable prices, and economic growth.

fiscal policy

Changes in government expenditures and/or taxes aimed at achieving economic goals, such as low unemployment, stable prices, and economic growth.

automatic fiscal policy

Changes in government expenditures and/or taxes that occur automatically without (additional) congressional action.

CROWDING OUT

Crowding out is the decrease in private expenditures that occurs as a consequence of increased government spending and/or the greater need to finance a budget deficit. The crowding-out effect suggests that expansionary fiscal policy does not work to the degree that Keynesian theory predicts. Complete (incomplete) crowding out occurs when the decrease in one or more components of private spending completely (partially) offsets the increase in government spending.

Contractionary Fiscal Policy

Decreases in government expenditures and/or increases in taxes in order to achieve economic goals.

Contractionary fiscal policy;Contractionary fiscal policy

Decreases in government expenditures and/or increases in taxes in order to achieve economic goals.; Government expenditures are down and/or taxes are up.

discretionary fiscal policy

Deliberate changes in government expenditures and/or taxes in order to achieve economic goals.

Why Demand-Side Fiscal Policy May Be Ineffective

Demand-side fiscal policy may be ineffective at achieving certain macroeconomic goals because of crowding out and lags.

Equal after-tax pay for equal work and a progressive income tax structure arenot always compatible with each other.

Equal after-tax pay for equal work and a progressive income tax structure are not always compatible. To illustrate, suppose two people are paid $1,000 for doing the same job. If one of them has a higher marginal tax rate, then that person will have less after-tax income. See Section: The Federal Budget

In the preceding scenario, is the discretionary fiscal policy needed to bring the economy closer to Natural Real GDP an example of expansionary fiscal policy or contractionary fiscal policy?

Expansionary As explained previously, policymakers attempt to move the economy out of the recessionary gap by implementing discretionary policy that stimulates aggregate demand. They do this by increasing government purchases and/or decreasing taxes. This is known as expansionary fiscal policy.

Fiscal Policy: General Remarks

Fiscal policy consists of changes in government expenditures and/or taxes to achieve economic goals. Expansionary fiscal policy advocates increases in government expenditures and/or decreases in taxes. Contractionary fiscal policy entails decreases in government expenditures and/or increases in taxes.

Use the following table to indicate which of the categories are counted in government expenditures and which are counted in government purchases.

Government expenditures are the sum of all government purchases and (government) transfer payments. Government purchases do not include transfer payments. See Section: The Federal Budget.

balanced budget

Government expenditures equal to tax revenues.

Budget Deficit

Government expenditures greater than tax revenues.

budget deficit

Government expenditures greater than tax revenues.

Deficits, Surpluses, and the Public Debt

If government expenditures are greater than tax revenues, a budget deficit results; if government expenditures are less than tax revenues, a budget surplus results. If government expenditures equal tax revenues, the budget is balanced. Budget deficits are predicted for the near future. A cyclical deficit is the part of the budget deficit that is a result of a downturn in economic activity. A structural deficit is the part of the deficit that would exist if the economy were operating at full employment. The public debt is the total amount that the federal government owes its creditors.

What percentage of all income taxes was paid by the top 5 percent of income earners in 2014? What percentage of total income did this income group receive in 2014?

In 2014, the top 5 percent of income earners received 35.96 percent of all income and paid 59.97 percent of all income taxes.

Government Spending

In 2016, the federal government spent $3.866 trillion, 21.1 percent of the country's GDP. About 67 percent of the money went for Social Security, Medicare, Income Security, and national defense. With a proportional income tax, everyone pays taxes at the same rate, regardless of income level. With a progressive income tax, a person pays taxes at a higher rate (up to some top rate) as his or her income level rises. With a regressive income tax, a person pays taxes at a lower rate as the person's income level rises. The federal income tax is a progressive income tax.

Taxes

In 2016, the federal government took in $3.276 trillion in tax revenues. Most of this amount came from three taxes: the individual income tax, the corporate income tax, and payroll taxes.

Demand-Side Fiscal Policy: A Keynesian Perspective

In Keynesian theory, demand-side fiscal policy can be used to rid the economy of a recessionary gap or an inflationary gap. A recessionary gap calls for expansionary fiscal policy, and an inflationary gap calls for contractionary fiscal policy. Ideally, fiscal policy changes aggregate demand by enough to rid the economy of either a recessionary gap or an inflationary gap.

We assume that any change in government spending is due to a change in government purchases, not to a change in transfer payments.

In other words, we assume that transfer payments are constant and therefore that changes in government spending are a reflection only of changes in government purchases.

Tax Base

In terms of income taxes, the total amount of taxable income.

expansionary fiscal policy

Increases in government expenditures and/or decreases in taxes in order to achieve particular economic goals.

Expansionary fiscal policy; Expansionary fiscal policy

Increases in government expenditures and/or decreases in taxes in order to achieve particular economic goals.;Government expenditures are up and/or taxes are down.

What four taxes account for the bulk of federal tax revenues?

Individual income tax, corporate income tax, Social Security taxes, and Medicare taxes.

The bulk of federal government expenditures go to four programs.

National defense,Medicare,Social Security, Income Security

If income tax rates rise, will income tax revenues rise too?

Not necessarily. A rise in revenues depends on whether the percentage rise in tax rates is greater than or less than the percentage fall in the tax base. Here's a simple example: Suppose the average tax rate is 10 percent and the tax base is $100. Then tax revenues equal $10. If the tax rate rises to 12 percent (a 20 percent rise) and the tax base falls to $90 (a 10 percent fall), then tax revenues rise to $10.80. In other words, if the tax rate rises by a greater percentage than the tax base falls, tax revenues rise. Now suppose that the tax base falls to $70 (a 30 percent fall) instead of to $90, then tax revenues would be $8.40. In other words, if the tax rate rises by a smaller percentage than the tax base falls, tax revenues fall.

Which of the following scenarios is an example of a data lag?

Policymakers obtain relevant economic data months after a recession has already begun.

Give an arithmetic example to illustrate the difference between the marginal and average tax rates

Suppose that a person's taxable income rises by $1,000 to $45,000 a year and that person's taxes rise from $10,000 to $10,390 as a result. Then her marginal tax rate—the percentage of additional taxable income she pays in taxes—is 39 percent. Her average tax rate—the percentage of her (total) income that she pays in taxes—is 23 percent.

budget surplus

Tax revenues greater than government expenditures.

Some economists argue for the use of fiscal policy to solve economic problems; some argue against it. Identify whether each argument in the following table is for the use of fiscal policy or against it.

The argument that "the economy is not always self-regulating" is for the use of fiscal policy. All remaining arguments are against the use of fiscal policy to solve economic problems. If the economy corrects itself quickly, or if there is crowding out, or if there are lags, then these are arguments against the use of fiscal policy. Complete crowding out occurs when a decrease in one or more components of private spending completely offsets the increase in government spending. Incomplete crowding out occurs when the decrease in one or more components of private spending only partially offsets the increase in government spending. If there were zero crowding out, then private sector spending would stay constant when government spending increased. There are five types of lags that could be associated with fiscal policy. The data lag involves the delay in receiving data about the state of the economy, which leads to policy makers not being aware of changes in the economy until after some time has passed. The wait-and-see lag is the lag that occurs when policy makers adopt a cautious stance and observe the economy for a while before implementing any policy changes. The legislative lag occurs due to the time that it takes to get new fiscal policy passed in Congress. The transmission lag is the time that it takes for fiscal policy to go into effect, and the effectiveness lag is the time it takes for the policy to cause changes in the economy. See Sections: "Crowding Out: Questioning Expansionary Fiscal Policy" and "Lags and Fiscal Policy".

Marginal (Income) Tax Rate

The change in a person's tax payment divided by the change in taxable income: ∆Tax payment ÷ ∆Taxable income.

For which of the following reasons does crowding out matter to the debate over the effectiveness of fiscal policy in being able to change Real GDP?

The correct answers are If complete crowding out is a regular phenomenon, fiscal policy will not change Real GDP and If there is little to no crowding out, then fiscal policy will change Real GDP. Complete crowding out occurs when a decrease in one or more of the components of private spending completely offsets an increase in government spending. If there is complete crowding out, then an increase in government spending will not cause aggregate demand to rise, so there would be no upward pressure on the price level. Incomplete crowding out occurs when a decrease in one or more of the components of private spending only partially offsets the increase in government spending. If there were zero crowding out, then private sector spending would remain constant when government spending increased. See Section: Crowding Out: Questioning Expansionary Fiscal Policy.

Which of the following describe how crowding out may occur?

The correct answers are Individuals substitute government goods for private goods and Financing the deficit pushes interest rates upward, causing investment to fall. Crowding out refers to a reduction in private spending that results from increased government spending or the need for the government to finance government borrowing. Crowding out can be direct or indirect as described in these two examples that follow: 1.Direct Effect: The government spends more on public libraries, and so people buy fewer books at privately owned bookstores.2.Indirect Effect: The government spends more on social programs and defense without increasing taxes; as a result, the size of the budget deficit increases. In the example of the indirect effect, the government must borrow more funds to finance the larger deficit. The increase in borrowing causes the demand for credit (that is, the demand for loanable funds) to rise, in turn causing the interest rate to rise. As a result, investment drops. Thus, more government spending indirectly leads to less investment spending. See Section: Crowding Out: Questioning Expansionary Fiscal Policy.

How can expansionary fiscal policy end up destabilizing the economy?

The correct answers are It can shift the AD curve too far to the right, so the new SRAS and AD curves intersect at a point greater than Natural Real GDP and It can shift the AD curve to the right at the same time that (unbeknownst to policy makers) the SRAS curve is shifting to the right, so the new SRAS and AD curves intersect at a point greater than Natural Real GDP. Fiscal policy makers have to be very careful about the underlying economy when they are implementing fiscal policy changes. An increase in AD that occurs when there is an unknown right shift occurring in SRAS, or an increase in AD that is too large, would lead to an equilibrium beyond the Natural Real GDP level. See Section: Lags and Fiscal Policy.

A cyclical deficit will disappear when the economy returns to full employment, while a structural deficit will not.

The correct answers are cyclical and structural, respectively. Suppose the budget is balanced and then Real GDP drops. The tax base of the economy will then drop as well, and if tax rates are held constant, then tax revenues will also drop. The fall in real GDP will also lead to an increase in transfer payments. This means that when Real GDP falls, government expenditures will rise, but government revenues will fall. Thus, a balanced budget will become a budget deficit. The cyclical deficit refers to that part of the budget deficit that results from a downturn in economic activity. The remainder of the deficit—the part that would exist if the economy were operating at full employment—is called the structural deficit. See Section: Structural and Cyclical Deficits.

The marginal tax rate is the rate paid on additional income, while the average tax rate is the rate paid on all income.

The correct answers are marginal and average, respectively. The marginal income tax rate is equal to the change in a person's tax payment divided by the change in the person's taxable income. The average tax rate is equal to an individual's tax payment divided by taxable income. See Sections: "Marginal Tax Rates and Aggregate Supply" and "The Laffer Curve: Tax Rates and Tax Revenues".

Laffer Curve

The curve, named after economist Arthur Laffer, that shows the relationship between tax rates and tax revenues. According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall with further increases in tax rates.

Explain the cyclical budget deficit.

The cyclical budget deficit is the part of the budget deficit that is the result of a downturn in economic activity.

Crowding Out

The decrease in private expenditures that occurs as a consequence of increased government spending or the need to finance a budget deficit.

Which of the following scenarios is an example of a transmission lag?

The economy enters a deep recession and Congress passes spending on public works that will take years to plan for and build.

Which of the following scenarios is an example of a legislative lag?

The economy enters a deep recession, and Congress takes two months to approve an extensive tax cut bill.

The Federal Budget

The federal budget has two not necessarily equal parts: government expenditures and tax revenues.

Complete the following table by identifying which lag is being described by each scenario.

The five types of lags include the data lag (policy makers are not aware of changes in the economy as soon as they happen); the wait-and-see lag (policy makers rarely enact counteractive measures immediately); the legislative lag (it can take months for policy makers to propose a fiscal policy measure, build support for it, and get it passed); the transmission lag (fiscal policy measures take time to be put into effect once enacted); and the effectiveness lag (after a policy measure is implemented, it takes time to affect the economy). See Section: Lags and Fiscal Policy.

Suppose a progressive tax system is implemented with a rate of 5% on income of $0-$40,000, a rate of 8% on income from $40,001 to $100,000, and a rate of 15% on all income over $100,000.

The newly implemented progressive income tax system yields less revenue than the proportional one. Under a progressive income tax system, a person's tax raterises as taxable his or her income rises.

cyclical deficit

The part of the budget deficit that is a result of a downturn in economic activity.

structural deficit

The part of the budget deficit that would exist even if the economy was operating at full employment.

Indicate whether each event in the following table is an example of automatic fiscal policy or discretionary fiscal policy

The rise in unemployment compensation benefits (in total) as a result of an increase in the unemployment rate is an example of an automatic fiscal policy, whereas Congress passing a policy consisting of lower taxes and higher government purchases is an example of discretionary fiscal policy. When changes in government expenditures and taxes are brought about deliberately through government actions, fiscal policy is said to be discretionary. In contrast, a change in either government expenditure or taxes that occurs automatically in response to economic events is referred to as automatic fiscal policy. See Section: Some Relevant Fiscal Policy Terms.

Tax revenue will never rise if tax rates are lowered.

The statement is false. Economist Arthur Laffer explained why lower taxes do not always lead to reduced tax revenues, through a diagram that became known as the Laffer curve. According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall with further increases in tax rates. The Laffer curve illustrates three points: (1) Zero tax revenues will be collected at two (marginal) tax rates: 0% and 100%. Obviously, no tax revenues will be raised if the tax rate is 0%, and if the tax rate is 100%, no one will work and earn income because the entire amount would be taxed away. (2) An increase in tax rates could cause tax revenues to increase, but only up to a maximal point. Thereafter, people would actually work less, and tax revenues would go down. (3) This leads to the third point, namely, that once the tax rate has risen beyond the point where tax revenues are maximized, a decrease in tax rates could cause tax revenues to increase. See Section: The Laffer Curve: Tax Rates and Tax Revenues.

Georgia Dickens is sitting with a friend at a coffee shop talking about the new tax bill. Georgia thinks that cutting tax rates at this time would be wrong. "Lower tax rates," she says, "will lead to a larger budget deficit, and the budget deficit is already plenty big."

The statement is false. Lower tax rates do not always mean a larger deficit. Economist Arthur Laffer explained why lower taxes do not always lead to reduced tax revenues, through a diagram that became known as the Laffer curve. According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall with further increases in tax rates. The Laffer curve illustrated three points: (1) Zero tax revenues will be collected at two (marginal) tax rates: 0% and 100%. Obviously, no tax revenues will be raised if the tax rate is 0%, and if the tax rate is 100%, no one will work and earn income because the entire amount would be taxed away. (2) An increase in tax rates could cause tax revenues to increase, but only up to a maximal point. Thereafter, people would actually work less and tax revenues would go down. (3) This leads to the third point, which shows that once the tax rate has risen beyond the point where tax revenues are maximized, a decrease in tax rates could cause tax revenues to increase. Thus, in this case, a decrease in tax rates would cause the budget deficit to fall, ceteris paribus. See Section: The Laffer Curve: Tax Rates and Tax Revenues.

Tax cuts that the public perceives to be temporary affect the SRAS and LRAS curves differently than tax cuts that are perceived to be permanent.

The statement is true. A cut in marginal tax rates increases the returns to investment and work effort and thus encourages people to increase the quantity of investment and labor resources they provide to the economy. A temporary tax cut results in temporary improvements in incentives to invest and work and thus causes a temporary rightward shift of the SRAS curve. A permanent tax cut, by contrast, represents a permanent increase in the investment and labor resources available to the economy and thus a rightward shift of both the SRAS and LRAS curves. See Section: Supply-Side Fiscal Policy.

Tax cuts will likely affect both aggregate demand and aggregate supply. True or False: It matters whether aggregate demand is affected more or whether aggregate supply is affected more.

The statement is true. It matters whether aggregate demand (AD) is affected more or whether aggregate supply (SRAS) is affected more. If both AD and SRAS increase, then real output will increase. However, the effect on the price level in the economy depends on the relative magnitudes of the changes in AD and SRAS. If AD increases by more than SRAS, then the price level will rise. If AD increases by less than SRAS, then the price level will fall. If AD and SRAS increase proportionally, then the price level will remain constant. See Section: Demand-Side Fiscal Policy.

Under a proportional income tax structure, a person who earns a high income will pay more in taxes than a person who earns a low income.

The statement is true. Under a proportional income tax structure, the same tax rate is charged for all income levels. Therefore, at higher incomes, the tax rate is applied to higher amounts. This means that, under a proportional tax structure, people with high incomes will pay more in taxes than people with low incomes. See Section: Income Tax Structures.

Three Income Tax Structures

The three income tax structures outlined are the progressive, proportional, and regressive structures.

After policy makers decide that some type of fiscal policy measure is required, Congress or the president has to propose the measure, build political support for it, and get it passed.

The time it takes to do all of this is referred to as the legislative lag.

public debt

The total amount that the federal government owes its creditors.

Suppose government spends $100 billion more and, as a result, the private sector spends $100 billion less.

This is representative of complete crowding out .

How much would a person with an income of $13,500 pay in taxes?

To determine the amount the person has to pay in taxes, you should have made the following calculation: $1,100+($13,500−$10,000)×0.15=$1,625$1,100+$13,500−$10,000×0.15=$1,625.

How much would a person with an income of $14,000 pay in taxes?

To determine the amount the person has to pay in taxes, you should have made the following calculation: $1,100+($14,000−$10,000)×0.15=$1,700$1,100+$14,000−$10,000×0.15=$1,700.

How much would a person with an income of $6,000 pay in taxes?

To determine the amount the person has to pay in taxes, you should have made the following calculation: $500+($6,000−$5,000)×0.12=$620$500+$6,000−$5,000×0.12=$620.

How much would a person with an income of $7,500 pay in taxes?

To determine the amount the person has to pay in taxes, you should have made the following calculation: $500+($7,500−$5,000)×0.12=$800$500+$7,500−$5,000×0.12=$800. See Section: Government Tax Revenues.

A rise in government expenditures combined with a rise in taxes is representative of expansionary fiscal policy.

True or false? false

Suppose the economy is in a recessionary gap and government increases government expenditures hoping to get the AD curve in the economy to shift right enough so that the economy is in long-run equilibrium. Instead, the AD curve does not move.

We would then say this situation is representative of complete crowding out.

Supply-Side Fiscal Policy

When fiscal policy measures affect tax rates, they may affect both aggregate supply and aggregate demand. It is generally accepted that a marginal tax rate reduction increases the attractiveness of work relative to leisure and tax-avoidance activities and thus leads to an increase in aggregate supply. Tax revenues equal the tax base multiplied by the (average) tax rate. Whether tax revenues decrease or increase as a result of a tax rate reduction depends on whether the percentage increase in the tax base is greater or less than the percentage reduction in the tax rate. If the percentage increase in the tax base is greater than the percentage reduction in the tax rate, then tax revenues will increase. If the percentage increase in the tax base is less than the percentage reduction in the tax rate, then tax revenues will decrease.

Identify whether each scenario in the following table is an example of complete crowding out or incomplete crowding out.

When the government spends $5 million on food stamps, and food stamp recipients then spend $2 million less, this is an example of incomplete crowding out. When the government spends $5 million on food stamps, and food stamp recipients then spend $5 million less, this is an example of complete crowding out. Complete crowding out occurs when a decrease in one or more components of private spending completely offsets the increase in government spending. Incomplete crowding out occurs when the decrease in one or more components of private spending only partially offsets the increase in government spending. If there were zero crowding out, then private sector spending would stay constant when government spending increased. See Section: Crowding Out: Questioning Expansionary Fiscal Policy.

Explain the differences among progressive, proportional, and regressive income tax structures.

With a proportional income tax, the tax rate is constant as one's income rises. With a progressive income tax, the tax rate rises as one's income rises (up to some point). With a regressive income tax, the tax rate falls as one's income rises.

Budget Surplus

an excess of tax revenue over government spending

Tax revenues equal the tax base times the

average tax rate.

The cyclical deficit is that part of the budget deficit that is a result of a

downturn in economic activity.

An increase in government expenditures and/or decreases in taxes in order to achieve macroeconomic goals is representative of

expansionary fiscal policy.

The marginal tax rate is equal to the tax payment divided by taxable income. True or false?

false

If government expenditures are greater than tax revenues, then the .

government is running a budget deficit

On the upward-sloping portion of the Laffer curve an increase in the tax rate will

increase tax revenues and a decrease in the tax rate will decrease tax revenues.

VAT

is a tax applied to the value added at each stage of production.

The VAT

is a tax applied to the value added at each state of production.

The federal debt or national debt

is the total amount that the federal government owes its creditors.

How much would a person with an income of $12,000 pay in taxes?

o determine the amount the person has to pay in taxes, you should have made the following calculation: $1,100+($12,000−$10,000)×0.15=$1,400$1,100+$12,000−$10,000×0.15=$1,400.

progressive income tax structure

pay higher tax rate on additional income

regressive income tax structure

pay lower tax rate on additional income.

proportional income tax structure

pay same tax rate on additional income

An income tax system in which a person's tax rate declines as his or her taxable income rises is representative of a(n)

regressive income tax.

An income tax system in which one's tax rate rises as taxable income

rises (up to some point) is representative of a progressive income tax.

The total budget deficit is the sum of the

structural deficit and the cyclical deficit.

total budget deficit=

structural deficit+ cyclical deficit

We deal only with discretionary fiscal policy

that is, deliberate actions on the part of policy makers to affect the economy through changes in government spending and/or taxes.

The economy is in a recessionary gap. Government raises government purchases by $200 billion. If there is zero crowding out,

the AD curve in the economy will shift to the right.

The bulk of government tax revenues comes from three taxes:

the individual income tax, the corporate income tax, and payroll taxes (which include Social Security and Medicare taxes).

In 2014, the top 10% of income earners earned 47.21% of

total income and paid 70.88% of federal income taxes.

In 2016, government expenditures were $3.866 trillion ,

while government tax revenue was $3.276 trillion .