Chapter 11: Fiscal Policy, Deficits, and Debt

proportional tax system

In a proportional tax system, the average tax rate remains constant as GDP rises

Council of Economic Advisers (CEA)

a group of three economists appointed by the president to provide expertise and assistance on economic matters.

administrative lag

(problem of timing) The wheels of democratic government turn slowly. There will typically be a signifigant lag between the time the need for fiscal action is recognized and the time action is taken.

A graphical look at crowding out

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Does the public debt burden future generations?

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contractionary fiscal policy

When demand-pull inflation occurs, a restictive or contractionary fiscal policy may help control it. Its options are the opposite of those used to combat recession. It can: 1. Decrease government spending 2. Raise taxes 3. Use some combination of those two policies

expansionary fiscal policy

When recession occurs, this may be in order. Has an example where ultimately, the economy depicted is suffering both recession and cyclical unemployment. At this point the government has three options: 1. increase government spending 2. reduce taxes 3. use some combination of the two

budget surplus

When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus-- tax revenues in excess of government spending.

What is the extreme of political considerations?

At the extreme, elected officials and political parties might collectively "hijack" fiscal policy for political purposes, cause inappropriate changes in AD, and therby cause (rather than avert) economic fluctuations.

budget deficit

If the Federal budget is balances at the outset, expansinary fiscal policy will create a government budget deficit-- government spending in excess of tax revenues.

regressive tax system

In a regressive tax system, the average tax rate falls as GDP rises.

What must we do when evaluating fiscal policy?

In evaluating the status of fiscal policy, we must adjust defecits and surpluses to eliminate automatic changes in tax revenues and compare the sizes of the adjusted budget deficits (or surpluses) to the levels of potential GDP.

What is the primary burden of the debt?

Many economists conclude that the primary burden of the debt is the annual interest cahrge accruing on the bonds sold to finance the debt. In 2005, interest on the total public debt was $184 billion, which is now the fourth-largest item in the Federal budget. Interest payments wer 1.5 percent of GDP in 2005. That percentage reflects th elevel of taxation required to pay the interest on the public debt. That is, in 2005 the Federal government had to collect taxes equal to 1.5 percent of GDP to service the total public debt.

What happens when you increase Government spending as part of expansionary fiscal policy?

Other things equal, a sufficient increase in government spending will shift an economy's AD curve to the right. But this initial increase in G is not the end of the story. The multiplier effect makes the curve shift further than the line AD2. Real output rises by the full extent of the multiplier. Concurrently, unemployment falls as firms increase their employment to the full-employment level tht existed before the recession.

Recent US fiscal policy

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public investments and public-private complementaries as part of the crowding out effect

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social security considerations

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What is the economic importance of the direct relationship between tax reciepts and GDP?

The economic importance becomes apparent when we consider -taxes reduce spending and AD -reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping Tax revenues automatically increase as GDP rises during prosperity, and since taxes reduce household and business spending, they restrain the economic expansion. That is, as the economy moves toward a higher GDP, tax revenues automatically rise and move the budget from defecit toward surplus. Conversely, as GDP falls during recession, tax revenues automatically decline, increasing spending and cushioning the economic contraction. With a falling GDP, tax reciepts decline and move the government's budget from surplus toward defecit.

How is fiscal policy offset by state and local finance?

The fiscal policy of state and local governments are frequently pro-cyclical, meaning they worsen rather than correct recession or inflation. Unlike the Federal government, most state and local governments face constitutional or other legal requiremnts to balance their budgets. Like households and private businesses, state and local governments increase their expenditures during prosperity and cut them during recession. During the Great Depression, most of the increase in Federal spending was offset by decreases in state and local spending. During ans immediately following the recession of 2001, many state and local governments had to increase tax rates, impose new taxes, and reduce spending to offset lower tax revenues resulting from the reduced personal income and spending of their citizens.

What is the main point with tax progressivity?

The more progressive the tax system, the greater the economy's built-in stability. The built-in stability has reduced the severity of business fluctuations. But built-in stabilizers can only diminish, not eliminate, swings in real GDP. Discretionary fiscal policy or monetary policy may be needed to correct recession or inflation of any appreciable magnitude.

public debt

The national or public debt is essentially the total accumulation of the deficits (minus the surpluses) the Federal government has incurred through time. These deficits have emerged mainly because of war financing, recessions, and fiscal policy. Lack of political will by the Congress has also contributed to the size of the debt.

progressive tax system

The steepness of T depends on the tax system itself. In a progressive tax system, the average tax rate (= tax revenue / GDP) rises with GDP. Steepest tax line.

What is the relationship between ownership of debt and US securities?

The total public debt represents the total amount of money owed by the Federal government to the holders of US securities.

Why are incentive a substansive issue with the public debt?

With no increase in the size of the debt, the interest charge must e paid out of tax revenues. Higher taxes may dampen incentives to bear risk, to innovate, to invest, and to work. So, in this indirect way, a large public debt may impair economic growth.

What are the problems of timing with fiscal policy?

1. recognition lag 2. administrative lag 3. operational lag

What are the political considerations regarding fiscal policy?

Fiscal policy is conducted in a political arena. That reality not only may slow down the enactment of fiscal policy but also may create th epotential for political considerations swamping economic considerations in its formulation. Politicians are human and want to get reelected. A strong economy at election time will certainly help them. So they may favor large tax cuts under the guise of expansionary fiscal policy even though that policy is economically inappropriate. Similarly, they may rationalize increased government spending on populat items such as farm subsidies, health care, highways, education, and homeland security.

U.S. securities

financial instruments issued by the Federal government to borrow money to finance expenditures that exceed tax revenues. These US securities are of four types: 1. treasury bills (short-term securities) 2. treasury notes (medium-term securities) 3. treasury bonds (long-term securities) 4. U.S. saving bonds (long-term, nonmarketbale bonds)

recognition lag

(problem of timing) The recognition lag is the time between the beginning of recession or inflation and the certain awareness that it is actually happening. This lag arises because of the difficulty in predicting the future course of economic activity. Although forecasting tools provide clues to the direction of the economy, the economy may be 4 or 6 months into a recession or inflation before that fact appears in relevant statistic and is acknowledged. Meanwhile, the economic downslide or the inflation may become more serious that it would have if the situation had been identified and acted on sooner.

How are debt and GDP related?

A simple statement of the absoulte size of the debt ignores the fact that the wealth and productive ability of the US economy is also vast. A wealthy, highly productive nation can incur and carry a large public debt more easily than a poor nation. A more meaningful measure of the public debt relates it to an economy's GDP.

crowding-out effect

Another flaw of fiscal policy is the crowding-out effect: an expansionary fiscal policy (deficit spending) may increase the interest rate and reduce private spending, thereby weakening or canceling the stimulus of the expansionary policy. Suppose economy is in recession, government increases spending, and the monetary authorities hold the supply of money constant. To finance budget deficit, the government borrows funds in the money market. The resulting increase in the demand for money raises the price paid for borrowing money: the interest rate. Because investment spending varies inversely with the interest rate, some investment will be choked off or crowded out.

How do you use the standardized budget?

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What is the current thinking on fiscal policy?

In view of the complications and uncertain outcomes, some economists argue that it is better not to engage in it at all. Believe monetary policy is a better stabilizer. But most economists believe fiscal policy remains an important, useful policy lever in the governments macroeconomic toolkit. The current popular view is that fiscal policy can help push the economy is a particular direction but cannot fine-tune it to a precise macroeconomic outcome. Many economists agree that monetary policy is a better month to month stabilizer.

Which is better to do: change government spending or taxes?

Is changing government spending or taxes preferable as a mans of eliminating recession or inflation? The answer depends largely on one's view as to whether the government is too large or too small. Economists who beleive there are many unmet social and infrastructure needs usually recomend that government spending be increased during recessions. In times of demand-pull inflation, the usually recommend tax icnreases. Both actions either expand or preserve the size of the government. Economists who think that the government is too large and inefficient usually advocate the opposite. The point is that discretionary fiscal policy designed to stabiliz the economy can be associated with either an expanding government or a contracting government.

Does the US public debt threath to bankrupt the Federal government? What are the reasons?

No, there are two main reasons: refinancing and taxation. 1. Refinaning: The public debt is easily refinanced. As portions of the debt come due on maturing treasury bills, notes, and bonds each month, the government does not cut expenditures or raise taxes to provide the funds required. Rather, it refinances the debt by selling new bonds and using proceeds to pay holders of the maturing bonds. The new bonds are in strong demand because lenders can obtain a relatively good interest return with no risk of default by the Federal government. 2. Taxation: The federal government ahs the constitutional authority to levy and collect taxes. A tax increase is government option for gaining sufficient revenue to pay interest and principal on the public debt. The federal government has the option to impose new taxes or increase existing tax rates if necessary to finance its debt.

What happens when you decrease government spending as part of contractionary fiscal policy?

Reduced government spending shifts the AD curve leftward to control demand-pull inflation. If the price level were downwardly flexible, the price level would return to P1, where it was before demand-pull inflation occured. That is deflation will occur. Unfortunately, the actual economy is not as simple as the example suggests. Increase is AD that expand real output beyond the full-employment level of output tend to ratchet the price level upward, but declines in AD do not seem to push the price level downward. So, stopping inflation is a matter of halting the rise of the price level, not trying to lower it the previous level. Demand-pull inflation usually is experienced as a continual rightward shift of the AD curve. Contractionary fiscal policy is designed to stop a further shift, not to restore a lower price level. Successful fiscal policy eliminates a continuing positive GDP gap and prevents the price level from continuing its inflationary rise.

How is foreign owned public debt a substantive issue?

The 25% of US debt held by citizens and institutions of foreign countries is an economic burden to Americans. Because we do not owe that portion of the debt "to ourselves," the payment if interest and principal on this external public debt enables foreigners to buy some of our output. In return for the benefits derived from borrowed funds, the US transfers goods and services to foreign lenders.

How is income distribution a substantive issue of public debt?

The distribution of government securities is highly uneven. Some people own much more than the $26,834-per-person portion of governmental securities; other people own less or none at all. In general, the ownership of the public debt is concentrated among wealthier groups, who own a large percentage of all stocks and bonds. With the tax system, income is transferred from people who, on average, have lower incomes to the higher-income bondholders. If greater income equality is one of society's goals, then this redistribution is undesirable.

What happens when you combine government spending increase and tax reduction as part of expansionary fiscal policy?

The government may combine spending increases and tax cuts to produce the desired initial increase in spending and the eventual increase in aggregate demand and real GDP.

How is the corwding out effect a substantive issue of public debt?

The idea that public borrowing drives up real interest rates, which reduces private investment spending. If the amount of current investment corwded out is extensive, future generations will iherit an economy with a smaller production capacity and, other things equal, a lower standard of living.

What happens when you decrease taxes as part of expansionary fiscal policy?

A reduction in taxes would shift the AD curve rightward. The mulitplier will determine how far the AD curve will move. You may have noted that a tax cut must be somewhat larger than the proposed increase in government spending if it is to achieve the same amount of rightward shift in the AD curve. This is because part of a tax reduction increases savings, rather than consumption.

standardized budget

Economists use the standardized budget to adjust the actual Federall budget defits and surpluses to eliminate the automatic changes in tax revenues. The standardized budget measures what the Federal budget deficit or surplus would be with existing tax rates and government spending levels if the economy had achieved its full-employment level of GDP each year. The idea is to essentially compare actual government expenditures with the tax revenues that would have occured in that year if the economy had achieved full-employment GDP. That procedure removes budget deficits or surpluses that arise simply because of chagnes in GDP and thus tell us nothing about changes is discretionary fiscal policy.

built-in stabilizer

anything that increases the government's budget defecit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget defecit) during an expansion without requiring explicit action by policymakers. This is precisely what the US tax system does. government expenditures are fixed and assumed to be independant of the level of GDP. Congress decides on the particular level of spending, but it does not determine the magnitude of tax revenues. Instead, it establishes tax rates, and the tax revenues then vary directly with the level of GDP that the economy achieves.

operational lag

(problem of timing) A lag also occurs between the time fiscal action is taken and the time that action affects output, employment, or the price level. Although changes in tax rates can be put into effect relatively quickly, government spending on public works requires long planning periods adn even longer periods of construction. Such spending is of questionable use in offsetting short periods of recession. Consequently, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool.

Discretionary vs. non-discretionary changes

Discretionary changes in government spending and taxes are at the option of the Federal government. They do not occur automatically. Changes that occur without congressional action are nondiscretionary ("passive", "automatic").

political business cycle

Elected officials may cause so-called political business cycles. Such scenerios are difficult to document and prove, but there is little doubt that political considerations weigh heavily in the formulation of fiscal policy.

What are the future policy reversals regarding fiscal policy?

Fiscal policy may fail to achieve its intended objectives if households expect future reversals of policy. Consider a tax cut. If taxpayers beleive the tax reduction is temporary, they may save a large portion of their tax saving, reasoning that tax rates will return to thier previous level in the future. At that time, they an draw on their extra saving to maintain their consumption. So a tax reduction thought to be temporary may not increase present consumption spending and AD by as much as our simple model suggests. The opposite may be true for a tax increase. If taxpayers think it is temporary, the may reduce their saving to pay the tax while maintianing thier present consumption. They may reason they can restore thier saving when the tax rate falls again. So the tax increase may not reduce current consumption and AD by as much as the policymakers desired.

What happens when you increase taxes as part of contractionary fiscal policy?

The government can use tax increases to reduce consumption spending. An increase in taxes moves the AD curve leftward in terms of the multiplier.

What happens when you combine government spending decreases and tax increases as part of contractionary fiscal policy?

The government may choose to combine spending decreases and tax increases in order to reduce AD and check inflation.

What is the built-in stability of fiscal policy?

To some degree, government tax revenues change automatically over the course of the business cycle and in ways that stabilize the government. The automatic response, or built-in stability, constitutes nondiscretionary budgetary policy and results from the makeup of most tax systems. The actual US tax system is such that net tax revenues vary directly with GDP. (net taxes = tax revenues-transfers and subsidies). Virtually any tax will yield more tax revenue as GDP rises. Transfer payments behave in the opposite way from tax revenues. Unemployment compensation payments and welfare payments decrease during economic expansion and increase during economic contraction.

consumption smoothing

To the extent that this so-called consumption smoothing (occuring from policy reversals) occurs over time, fiscal policy will lose some of its strength. The lesson is that tax-rate chagnes that households view as permanent are more likely to alter consumption and AD than tax changes they view as temporary.