Econ 104:Fiscal Policy
What are three categories of federal government expenditures?
-Interest on the National Debt (payments to holders of the bonds the federal government has issued to borrow money) -Grants to State and Local Governments -Transfer Payments
What is the multiplier effect?
What economists call the series of induced increases in consumption spending that results from an initial increase in autonomous expenditures -Economists refer to the initial increase in government purchases as autonomous because it is a result of a decision by the government and is not directly caused by changes in the level of real GDP. -The increases in consumption spending that result from the initial autonomous increase in government purchases are induced because they are caused by the initial increase in autonomous spending.
What are some short-run effects on GDP?
-Expansionary fiscal policy involves increasing government purchases or decreasing taxes. -Contractionary fiscal policy involves decreasing government purchases or increasing taxes. -It is extremely difficult for Congress and the president to use fiscal policy to eliminate the effects of the business cycle and keep real GDP always equal to potential GDP. -A contractionary fiscal policy causes the price level to rise by less than it would have risen without the policy.
What is the difference between government purchases and government expenditures?
-Government expenditures include purchases plus government spending—such as Social Security payments by the federal government or pension payments to retired police officers by local governments—that does not involve purchases. -When the federal government purchases an aircraft carrier or the services of an FBI agent, or when a local government hires a teacher, the government receives a good or service in return.
Did the stimulus package of 2009 succeed?
-Many economists believe that consumers base their spending on their permanent income rather than just on their current income. -A consumer's permanent income reflects the consumer's expected future income. By basing spending on permanent income, a consumer can smooth out consumption over a period of years. -Some people have difficulty borrowing against their future income because banks or other lenders may not be convinced that a borrower's future income will be significantly higher than his or her current income. -One-time tax rebates, such as the one in 2008, increase consumers' current income but not their permanent income. -Therefore, a tax rebate is likely to increase consumption spending less than would a permanent tax cut.
How do economists measure government spending?
Economists often measure government spending relative to the size of the economy by calculating government spending as a percentage of GDP.
How can we measure the effectiveness of the stimulus package?
To judge the effectiveness of the stimulus package, we have to measure its effects on real GDP and employment, holding constant all other factors affecting real GDP and employment. -This includes the Fed's monetary policy and the typical changes in real GDP and employment during a business cycle. -By 2014, the effects of the stimulus package were small because several years had passed since most of the temporary spending increases and tax cuts had ended and because the economy had gradually moved back toward potential GDP.
How is crowding out affected in the long-run?
-Most economists agree that in the short run, an increase in government purchases results in partial, but not complete, crowding out. In the long-run, most economists agree that the result is complete crowding out. -In the long run, the decline in investment, consumption, and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. in the long run, real GDP returns to potential GDP. -There has been complete crowding out: Private expenditures have fallen by the same amount that government spending has increased. If government spending is taking a larger share of GDP, then private spending must take a smaller share. -In the long run, any permanent increase in government spending as a percentage of GDP must come at the expense of private expenditures. It may take several years to arrive at this long-run outcome.
What would cutting corporate tax rates do to the aggregate supply?
-The United States is unusual in imposing taxes on corporate earnings wherever they are earned but allowing corporations to postpone paying the taxes until the profits are brought back to the United States. -As a result, many U.S. corporations keep the bulk of their overseas profits outside the United States. -They can't use these funds in the United States to build new facilities or engage in research and development, and they can't return them to shareholders.
How is crowding out affected in the short-run?
-The greater the sensitivity of consumption, investment, and net exports to changes in interest rates, the more crowding out will occur. -Crowding out may reduce the effectiveness of an expansionary fiscal policy.
What does the long-run growth of real GDP depend on?
-The growth in the number of hours worked. -The growth rate of labor productivity as measured by the growth in real GDP per hour worked. -Real GDP = Number of hours worked × (Real GDP/Number of hours worked). -Growth rate of real GDP=Growth rate of hours worked+ Growth rate of labor productivity. -The growth rate of hours worked depends on the rate of population growth, changes in the employment-population ratio, and changes in the hours each employee works.
How do changes in tax rates affect GDP?
A change in the tax rate has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. -The value of the tax rate affects the size of the multiplier effect. The higher the tax rate, the smaller the multiplier effect. -cut in the tax rate increases the disposable income of households, which leads them to increase their consumption spending, and a cut in the tax rate increases the size of the multiplier effect.
What is CBO (Congressional Budget Office)?
A nonpartisan organization, and many economists believe its estimates on the effectiveness of the stimulus package are reasonable. -Because the estimates depend on particular assumptions about the size of the government purchases and tax multipliers, some economists believe that the CBO estimates are too high, while other economists believe the estimates are too low. -To reflect the uncertainty in its calculation, the CBO provides a range of estimates. -If the CBO's estimates of the effects of the stimulus package are accurate, then this fiscal policy action reduced the severity of the recession of 2007-2009 and its aftermath. However, relative to the severity of the recession, the effect of the package was comparatively small.
Why is simplifying the tax codes important?
A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments. -The complexity of the tax code, which is 3,000 pages long, has created a whole industry of tax preparation services, such as H&R Block. -The Internal Revenue Service estimates that taxpayers spend more than 6.4 billion hours each year filling out their tax forms
Should the federal budget always be balanced?
Although many economists believe that it is a good idea for the federal government to have a balanced budget when real GDP is at potential GDP, few economists believe that the federal government should attempt to balance its budget every year. -To bring the budget back into balance, the government would have to raise taxes or cut spending, but these actions would reduce aggregate demand, thereby making the recession worse. -To balance the budget every year, the government might have to take actions that would destabilize the economy.
What is the American Recovery and Reinvestment Act of 2009?
An $840 billion program of spending increases and tax cuts that was by far the largest fiscal policy action in U.S. history. -Although the tax rebates helped increase aggregate demand, the recession worsened in September 2008, following the bankruptcy of the Lehman Brothers investment bank and the deepening of the financial crisis. -About two-thirds of the stimulus package took the form of increases in government expenditures, and one-third took the form of tax cuts. -Spending increases included funds for infrastructure spending, biomedical research, and grants to state governments to help fund Medicare spending. -Individual tax cuts included a $400 reduction in payroll taxes for workers earning up to $75,000 per year and a tax credit of up to $2,500 for tuition and other college expenses.
How do you measure the government purchase multiplier?
Change in Equilibrium Real GDP/Change in Government Pucharses (1/1-mpc). -Tax Multiplier=Change in Equilibrium Real GDP/Change in Taxes (-mpc/1-mpc). -The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions because an increase in taxes reduces disposable income, consumption, and real GDP. -We would expect the tax multiplier to be smaller in absolute value than the government purchases multiplier because the whole of the $100 billion in government purchases results in an increase in aggregate demand. But households will save rather than spend some portion of a $100 billion decrease in taxes, and they will spend some portion on imported goods.
What is fiscal policy?
Changes in federal taxes and purchases that are intended to achieve macroeconomic policy goals. -Since the end of World War II, the federal government has been committed under the Employment Act of 1946 to intervening in the economy "to promote maximum employment, production, and purchasing power." -State and local governments sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because they are not intended to affect the national economy.
How can fiscal policy affect GDP?
Congress and the president carry out fiscal policy through changes in government purchases and taxes. -Because these changes cause increases and decreases in aggregate demand, they can be used to affect short-run levels of real GDP, employment, and the price level. -Countercyclical Policies-Congress and the president intend them to offset the effects of the business cycle.
What would cutting taxes on dividends and capital gains do to the aggregate supply?
Corporations distribute some of their profits to shareholders in the form of payments known as dividends. -Shareholders also may benefit from higher corporate profits by receiving capital gains. -A capital gain is the increase in the price of an asset, such as a share of stock. -Once when a corporation pays the corporate income tax on its profits and a second time when individual investors receive the profits in the form of dividends or capital gains. -Economists debate the costs and benefits of a separate tax on corporate profits. -Lowering the tax rates on dividends and capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate.
Why is estimating the exact number of the multiplier difficult?
Estimating an exact number for the multiplier is difficult because over time several factors can cause the aggregate demand and short-run aggregate supply curves to shift, leading to a change in equilibrium real GDP. -As a result, it can be challenging to isolate the effect of an increase in government purchases on equilibrium GDP. -Economists have been debating the size of these multipliers for many years. -When British economist John Maynard Keynes and his followers first developed the idea of spending and tax multipliers in the 1930s, they argued that the government purchases multiplier might be as large as 10. -Later research by economists indicated that the government purchases multiplier was much smaller, perhaps less than 2.
Does government spending reduce private spending?
Even if Congress and the president correctly time fiscal policy, the size of the multiplier effect may be limited if the increase in government purchases causes one of the nongovernment, or private, components of aggregate expenditures—consumption, investment, or net exports—to fall. -A decline in private expenditures as a result of an increase in government purchases is called crowding out.
What are some limits on using fiscal policy to stabilize the economy?
Getting the timing right can be more difficult with fiscal policy than with monetary policy for two main reasons. -Control over monetary policy is concentrated in the hands of the Federal Open Market Committee, which can change monetary policy at any of its meetings. -Even after a change in fiscal policy has been approved, it takes time to implement.
What are automatic stabilizers?
Government spending and taxes that automatically increase or decrease along with the business cycle and they happen without government action. -Ex-When the economy is expanding and employment is increasing, government spending on unemployment insurance payments to workers who have lost their jobs will automatically decrease. -With discretionary fiscal policy, the government takes actions to change spending or taxes.
Is government debt a problem?
If the debt becomes very large relative to the economy, however, the government may have to raise taxes to high levels or cut back on other types of spending to make the interest payments on the debt. -Interest payments are currently about 11 percent of total federal expenditures. -In the long run, a debt that increases in size relative to GDP can pose a problem. The CBO projects that if present trends continue, federal government debt will increase from 77 percent of GDP in 2017 to 150 percent in 2047.
How can the federal budget serve as an automatic stabilizer?
In many milder recessions, though, no significant discretionary fiscal policy actions are taken. -Most of the increase in the federal budget deficit during a typical recession takes place without Congress and the president taking any action but is instead due to the effects of the automatic stabilizers
What are the economic effects of tax reforms?
Increases in the labor force and the capital stock and the technological change that would occur even without tax reduction and simplification. -If tax reduction and simplification are effective, the economy will experience increases in the labor supply, thereby increasing the number of hours worked. Saving, investment, the formation of new firms, and economic efficiency will also increase, thereby increasing labor productivity. -Some economists believe that tax changes have only a small effect on saving and investment.
What are cyclically adjusted budget deficit or surplus?
Measures what the deficit or surplus would be if real GDP were at potential GDP. -Provide a more accurate measure of the effects on the economy of the government's spending and tax policies than can the actual budget deficit or surplus. -When the federal government runs an expansionary fiscal policy, the result is a cyclically adjusted budget deficit. -When the federal government runs a contractionary fiscal policy, the result is a cyclically adjusted budget surplus.
How can fiscal policy affect long-run economic growth?
Most fiscal policy actions that attempt to increase long-run real GDP growth do so by changing taxes to increase incentives to work, save, invest, and start a business. -Tax Wedge-The difference between the pretax and posttax return to an economic activity. -The tax wedge is determined by the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes. -When workers, savers, investors, or entrepreneurs change their actions as a result of a tax change, economists say that there has been a behavioral response to the tax change.
What would cutting individual tax rates do to the aggregate supply?
Reducing the marginal tax rates on individual income will reduce the tax wedge workers face, thereby increasing the quantity of labor supplied. -Many small businesses are sole proprietorships, whose profits are taxed at the individual income tax rates, therefore cutting the individual income tax rates also raises the return to entrepreneurship, encouraging the opening of new businesses.
What does the federal government do when it's running a deficit?
The Treasury must borrow funds from investors by selling Treasury bond. -The total value of U.S. Treasury bonds outstanding is called the federal government debt or, sometimes, the national debt. Each year the federal budget is in deficit, the federal government debt grows. Each year the federal budget is in surplus, the debt shrinks.
What is a dynamic aggregate demand and aggregate supply model?
The discussion of expansionary and contractionary fiscal policy is simplified, however, because it ignores that the economy experiences continuing inflation, with the price level rising every year and the economy experiences long-run growth, with the LRAS curve shifting to the right every year.
