Week 9
progressive tax
- A tax that collects a greater share of income from those with high incomes than from those with lower incomes. - This is the system the U.S. uses.
types of fiscal policy
- Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. - Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes.
crowding out
- Federal spending and borrowing causes interest rates to rise and business investment + household consumption to fall. - During a recession, most businesses are not investing in capital or expansion plans, so the risk is much smaller. However, during a period of growth, the risk becomes greater
Fiscal policy
- Fiscal policy is the set of policies that relate to federal government spending, taxation, and borrowing. - Fiscal policy is conducted both through discretionary fiscal policy, which occurs when the government enacts taxation or spending changes in response to economic events, or through automatic stabilizers, which are taxing and spending mechanisms that, by their design, shift in response to economic events without any further legislation.
most common gov expenditures
- SS + Medicare - national defense + VA - social programs - physical, human, and community development
point
- Tax revenues vary directly with GDP; income, sales, excise, and payroll taxes all increase when the economy is expanding (more people are working) and all decrease when the economy is contracting (people are getting laid off).
personal income tax
- a tax based on the income, of all forms, received by individuals - backbone of the U.S. federal tax system
regressive tax systems
- a tax in which people with higher incomes pay a smaller share of their income in tax - sales taxes are considered to be regressive
gov debt
- accumulation of all deficits
fiscal policy
- changes in government expenditures and taxations in order to achieve particular macroeconomic goals - tax cuts affect household and business sectors
Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer: Rising inflation
- contractionary, to fight inflation - change will shift ad to the left
Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer: extremely rapid growth of exports
- contractionary, to fight inflation - this change shifts ad to the left
point
- expansionary fiscal policy can be considered effective when no crowding out occurs
Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer: A rise in oil prices.
- expansionary to stimulate demand - the sras curve shifted to the left due to higher prices - this change will shift ad to the right
contractionary fiscal policy
- fiscal policy that decreases the level of aggregate demand, either through cuts in government spending or increases in taxes - when demand-pull inflation occurs, contractionary policy is the remedy - will create a surplus - problem with inflation is that aggregate demand is too high - useful when you have inflationary gap
expansionary fiscal policy
- fiscal policy that increases the level of aggregate demand, either through increases in government spending or cuts in taxes - used to combat a recession - problem during a recession is that aggregate demand is too low, so increasing government spending and/or a reduction in taxes will increase aggregate demand - will create a deficit - useful when you have recessionary gap
most common tax revenue sources for gov
- personal income tax - corporate income tax - payroll tax
primary source of revenue for state and local tax revenues
- primary source of state tax revenues comes from sales and excise taxes - personal and corporate income taxes are the second most significant source - state and local tax revenues have increased to match the rise in state and local spending
types of income tax
- progressive - proportional/flat - regressive
types of time lags in fiscal policy
- recognition lag - wait and see lag - legislative lag - implementation lag - effectiveness lag
automatic stability
- tax and spending rules that have the effect of slowing down the rate of decrease in aggregate demand when the economy slows down and restraining aggregate demand when the economy speeds up, without any additional change in legislation - automatic stability reduces instability, but does not eliminate economic instability - built-in stability arises because net taxes change with GDP (recall that taxes reduce incomes and, therefore, spending)
discretionary fiscal policy
- the government passes a new law that explicitly changes overall tax or spending levels with the intent of influencing the level or overall economic activity - deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth
point
- the size of automatic stability depends on the responsiveness of changes in taxes to changes in GDP - The more progressive the tax system, the greater the economy's built-in stability. A progressive tax system means the average tax rate rises with GDP (the more you earn, the more you pay) - tax revenues vary directly with GDP
Total gov debt/national debt
- the sum of budget deficits and budget surpluses over time - The total accumulated amount the government has borrowed, over time, and not yet paid back - About 73% of government spending goes to four major areas: national defense, Social Security, healthcare, and interest payments on past borrowing. This leaves about 29% of federal spending for all other functions of the U.S. government (see the chart in Figure 2). - Deficits (and by extension the debt) are the result of war financing, recessions, and lack of political will to reduce or avoid them
marginal tax rate
- the tax that must be paid on all yearly income - tax rate paid on additional income
implementation lag
- the time it takes for the funds relating to fiscal policy to be dispersed to the appropriate agencies to implement the programs
recognition lag
- the time it takes to determine that a recession has occurred - takes the National Bureau of Economic Research (NBER) crunching the data for two consecutive quarters to determine if we're in a recession
legislative lag
- the time it takes to get a fiscal policy bill passed - a legislative lag is the difficulty in changing policy once the problem has been recognized
wait and see lag
- when policy makers become aware of a downturn in economic activity, they rarely enact counteractive measures immediately - waiting to see if economy will self-correct or should be adjusted
payroll tax
A tax based on the pay received from employers; the taxes provide funds for Social Security and Medicare.
corporate income tax
A tax imposed on corporate profits.
excise taxes
A tax on a specific good—on gasoline, tobacco, and alcohol
estate and gift taxes
A tax on people who pass assets to the next generation—either after death or during life in the form of gifts
proportional tax
A tax that is a flat percentage of income earned, regardless of level of income.
debt/gdp ratio
Annual deficits do not always mean that the debt/GDP ratio is rising. During the 1960s and 1970s, the government often ran small deficits, but since the debt was growing more slowly than the economy, the debt/GDP ratio was declining over this time. In the 2008-2009 recession, the debt/GDP ratio rose sharply.
point
Federal tax revenues have been about 17-20% of GDP during most periods in recent decades. The primary sources of federal taxes are individual income taxes and the payroll taxes that finance Social Security and Medicare.
point
Given the uncertainties over interest rate effects, time lags (implementation lag, legislative lag, and recognition lag), temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers have concluded that discretionary fiscal policy is a blunt instrument and better used only in extreme situations.
point
In this well-functioning economy (Figure 9), each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.
point
Overall, you can look at anywhere from six months to well over a year before fiscal policy is completed. This could cause a problem if the economy has self-corrected and has started to grow again. This could lead to demand-pull inflation.
point
The economy starts at the equilibrium quantity of output Y0, which is above potential GDP (Figure 11). The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD0 to AD1, leading to a new equilibrium output E1, which occurs at potential GDP, where AD1 intersects the LRAS curve.
point
The original equilibrium (E0) represents a recession (Figure 10), occurring at a quantity of output (Y0) below potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP, which the LRAS curve shows. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.
point
When a government borrows money in the financial capital market (Figure 12), it causes a shift in the demand for financial capital from D0 to D1. As the equilibrium moves from E0 to E1, the equilibrium interest rate rises from 6% to 7%. In this way, an expansionary fiscal policy intended to shift aggregate demand to the right can also lead to a higher interest rate, which has the effect of shifting aggregate demand back to the left.
balanced budget
When government spending and taxes are equal.
budget deficit
When the federal government spends more money than it receives in taxes in a given year.
budget surplus
When the government receives more money in taxes than it spends in a year.
Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer: a rise in the natural rate of unemployment
While an expansionary fiscal policy could be used to stimulate AD and employment, this would have no long run effect on the natural rate of unemployment, simply a higher price level.
If an economy moves into a recession, causing that country to produce less than potential GDP, then:
automatic stabilizers will cause tax revenue to decrease and government spending to increase.
If government tax policy requires Peter to pay $15,000 in tax on annual income of $200,000 and Paul to pay $10,000 in tax on annual income of $100,000, then the tax policy is:
regressive
effectiveness lag
the time needed for changes in monetary or fiscal policy to affect the economy
When inflation begins to climb to unacceptable levels in the economy, the government should:
use contractionary fiscal policy to shift aggregate demand to the right
