CHAPTER 17: GOVERNMENT BUDGETS AND FISCAL POLICY Self-Check Questions

Is Medicaid (federal government aid to low-income families and individuals) an automatic stabilizer?

Yes. In a recession, as more families become classified as low-income, Medicaid spending will increase, causing aggregate demand to rise.

What are the main categories of U.S. federal government taxes?

Individual income tax, payroll tax, corporate income tax and capital gains tax.

What taxes would an individual pay if he were self-employed and the business is not incorporated?

Individual income taxes

If a government runs a budget deficit of $10 billion dollars each year for ten years, then a surplus of $1 billion for five years, and then a balanced budget for another ten years, what is the government debt?

($10 billion x 5) - ($1 billion x 10) + (0 x 10) = $40 billion.

What are some practical weaknesses of discretionary fiscal policy?

Discretionary fiscal policy allows lobbyists to convince Congress to spend on their behalf, at the expense of others, and encourages Congressmen to engage in pork-barrel projects for their own districts to curry favor with voters

What is the difference between a budget deficit, a balanced budget, and a budget surplus?

A budget surplus occurs when a government takes in more tax revenue than it spends, a budget deficit is when it spends more than it takes in and a balanced budget is when the two amounts are equal.

Do you agree or disagree with this statement: "It is in the best interest of our economy for Congress and the President to run a balanced budget each year." Explain your answer.

A matter of opinion for the student to provide

Give some examples of changes in federal spending and taxes by the government that would be discretionary fiscal policy and some that would not.

A new infrastructure project or an increase in the income tax rate would be examples of fiscal policy, but increased spending due to changes in the interest rate on federal bonds or increased tax revenues due to rising national income would not be examples of fiscal policy.

What is the difference between a progressive tax, a proportional tax, and a regressive tax?

A progressive tax has an increasing rate for higher income individuals, a regressive tax has a decreasing rate and a proportional tax charges the same rate regardless of income.

What's the difference between discretionary fiscal policy and automatic stabilizers?

Discretionary fiscal policy must be enacted through Congress, while automatic stabilizers take place without any legislative action being necessary.

What are some of the arguments for and against a requirement that the federal government budget be balanced every year?

Arguments for a balanced budget are that the national debt is damaging over the long term due to the rising costs of interest payments, and forcing a balance every year disciplines Congress not to spend too much. Arguments against a balanced budget are that the Congress needs to have flexibility in spending to respond to recessions with fiscal policy.

Why do automatic stabilizers function "automatically?"

Automatic stabilizers are structured in such a way that spending increases when the economy suffers, such as when more people apply for unemployment benefits.

What is the main advantage of automatic stabilizers over discretionary fiscal policy?

Automatic stabilizers take effect very quickly, whereas discretionary policy can take a long time to implement.

What has been the general pattern of U.S. budget deficits in recent decades?

Budget deficits have generally expanded in recent decades.

During the Great Recession of 2008-2009, what actions would have been required of Congress and the President had a balanced budget amendment to the Constitution been ratified? What impact would that have had on the unemployment rate?

Congress would not have been able to increase government spending to stimulate the economy without either increasing taxes or reducing spending in other areas. Economists have debated the effects of the stimulus package, but there may have been larger amounts of unemployment as a result.

If an individual owns a corporation for which he is the only employee, which different types of federal tax will he have to pay?

Corporate income tax on his profits, individual income tax on his salary, and payroll tax taken out of the wages he pays himself.

How will cuts in state budget spending affect federal expansionary policy?

Cuts in state budget spending will partially offset increases in federal spending as part of an expansionary fiscal policy.

What would happen if contractionary fiscal policy were implemented during an economic boom but, due to lag, it did not take effect until the economy slipped into recession?

Employment would suffer as a result of too little spending.

What is the difference between expansionary fiscal policy and contractionary fiscal policy?

Expansionary fiscal policy increases spending to boost aggregate demand, while contractionary fiscal policy reduces spending to keep prices down.

Is expansionary fiscal policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government? Explain your answer

Expansionary fiscal policy is more attractive to politicians who believe in larger government, since it involves increasing government spending.

Why is spending by the U.S. government on scientific research at NASA fiscal policy while spending by the University of Illinois is not fiscal policy? Why is a cut in the payroll tax fiscal policy whereas a cut in a state income tax is not fiscal policy?

Fiscal policy is conducted at the national level in order to affect the entire country. State and local expenditures have localized effects and are not considered fiscal policy.

Under what general macroeconomic circumstances might a government use expansionary fiscal policy? When might it use contractionary fiscal policy?

Governments tend to use expansionary fiscal policy during recessions and contractionary fiscal policy during economic booms.

What is a potential problem with a temporary tax decrease designed to increase aggregate demand if people know that it is temporary?

If people know that the tax decrease is temporary, they will not be as likely to spend their money, but instead will save it, and the expected rise in aggregate demand will not occur.

Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy is producing more than potential GDP.

In a recession, because of the decline in economic output, less income is earned, and so less in taxes is automatically collected. Many welfare and unemployment programs are designed so that those who fall into certain categories, like "unemployed" or "low income," are eligible for benefits. During a recession, more people fall into these categories and become eligible for benefits automatically. The combination of reduced taxes and higher spending is just what is needed for an economy in recession producing below potential GDP. With an economic boom, average income levels rise in the economy, so more in taxes is automatically collected. Fewer people meet the criteria for receiving government assistance to the unemployed or the needy, so government spending on unemployment assistance and welfare falls automatically. This combination of higher taxes and lower spending is just what is needed if an economy is producing above its potential GDP.

In a recession, does the actual budget surplus or deficit fall above or below the standardized employment budget?

It falls below because less tax revenue than expected is collected.

In a booming economy, is the federal government more likely to run surpluses or deficits? What are the various factors at play?

It is more likely to run surpluses, because the greater amount of income will produce more tax revenue, and government spending should be relatively low to hold down the rate of inflation.

Why is government spending typically measured as a percentage of GDP rather than in nominal dollars?

It is more meaningful to look at spending in terms of the entire output of the economy, because nominal dollars offer no information about the context of the spending.

Economist Arthur Laffer famously pointed out that, in some cases, income tax revenue can actually go up when tax rates go down. Why might this be the case?

Lower tax rates can stimulate demand and create more jobs and income for the nation as a whole. The greater amount of income, taxed at a lower rate, can sometimes produce higher tax revenues than a smaller amount of income taxed at a higher rate.

Suppose that gifts were taxed at a rate of 10% for amounts up to $100,000 and 20% for anything over that amount. Would this tax be regressive or progressive?

Progressive. People who give larger gifts subject to the higher tax rate would typically have larger incomes as well.

Do you think the typical time lag for fiscal policy is likely to be longer or shorter than the time lag for monetary policy? Explain your answer?

Monetary policy probably has shorter time lags than fiscal policy. Imagine that the data becomes fairly clear that an economy is in or near a recession. Expansionary monetary policy can be carried out through open market operations, which can be done fairly quickly, since the Federal Reserve's Open Market Committee meets six times a year. Also, monetary policy takes effect through interest rates, which can change fairly quickly. However, fiscal policy is carried out through acts of Congress that need to be signed into law by the president. Negotiating such laws often takes months, and even after the laws are negotiated, it takes more months for spending programs or tax cuts to have an effect on the macroeconomy.

What would happen if expansionary fiscal policy was implemented in a recession but, due to lag, did not actually take effect until after the economy was back to potential GDP?

Prices would be pushed up as a result of too much spending.

How would a balanced budget amendment change the effect of automatic stabilizer programs?

Programs where the amount of spending is not fixed, but rather determined by macroeconomic conditions, such as food stamps, would lose a great deal of flexibility if spending increases had to be met by corresponding tax increases or spending cuts.

What is the benefit of having state and local taxes on income instead of collecting all such taxes at the federal level?

State and local governments can use that revenue to benefit the local community more effectively, whereas the federal government is more likely to spend the money elsewhere.

Why are expenditures such as crime prevention and education typically done at the state and local level rather than at the federal level?

States and cities are in a better position to judge their needs in these areas, and it is also deemed fairer to only tax residents of the affected area in order to pay for these programs.

What is the difference between a budget deficit and the national debt?

The budget deficit is the difference between tax revenue and spending in a given year. The nation debt is the accumulation of all past deficits.

When governments run budget surpluses, what is done with the extra funds?

The funds can be used to pay down the national debt or else be refunded to the taxpayers.

When governments run budget deficits, how do they make up the differences between tax revenue and spending?

The government borrows funds by selling Treasury bonds, notes, and bills.

How would a balanced budget amendment affect a decision by Congress to grant a tax cut during a recession?

The government would have to make up the revenue either by raising taxes in a different area or cutting spending.

What are the main categories of U.S. federal government spending?

The main categories are national defense, Social Security and Medicare payments, and interest on the debt.

What is the standardized employment budget?

The standardized employment budget describes what the unemployment rate would be if the economy were producing at potential GDP.

If the government gives a $300 tax cut to everyone in the country, explain the mechanism by which this will cause interest rates to rise.

The tax cut stimulates aggregate demand, which causes prices to rise. Higher prices will cause lenders to demand a higher interest rate on loans in order to ensure the same real return on investment.

The social security tax is 6.2% on employees' income earned below $113,000. Is this tax progressive, regressive or proportional?

The tax is regressive because wealthy income earners are not taxed at all on income above $113,000. As a percent of total income, the social security tax hits lower income earners harder than wealthier individuals.

A government starts off with a total debt of $3.5 billion. In year one, the government runs a deficit of $400 million. In year two, the government runs a deficit of $1 billion. In year three, the government runs a surplus of $200 million. What is the total debt of the government at the end of year three?

The total debt is $3.5 billion + $400 million + $1 billion - $200 million = $4.7 billion.

Excise taxes on tobacco and alcohol and state sales taxes are often criticized for being regressive. Although everyone pays the same rate regardless of income, why might this be so?

These products tend to be more heavily purchased by low-income individuals, so the tax they pay constitutes a higher share of their income than it would for a high-income buyer.

Have spending and taxes by state and local governments in the United States had a generally upward or downward trend in the last few decades?

They have had a generally upward trend.

Have the spending and taxes of the U.S. federal government generally had an upward or a downward trend in the last few decades?

They have remained mostly flat, while increasing in the last couple of years.

What is the main reason for employing expansionary fiscal policy during a recession?

To increase employment.

What is the main reason for employing contractionary fiscal policy in a time of strong economic growth?

To keep prices from rising too much or too rapidly.

Is it possible for a nation to run budget deficits and still have its debt/GDP ratio fall? Explain your answer. Is it possible for a nation to run budget surpluses and still have its debt/GDP ratio rise? Explain your answer.

Yes to both of these. A budget deficit is an increase in a nation's debt. If GDP is expanding faster than the growth of debt, the debt to GDP ratio will fall. Conversely, if a nation's GDP is rising more slowly than its debt, the debt to GD ratio will rise.

Is it possible for a nation to run budget deficits and still have its debt/GDP ratio fall? Explain your answer. Is it possible for a nation to run budget surpluses and still have its debt/GDP ratio rise? Explain your answer.

Yes, a nation can run budget deficits and see its debt/GDP ratio fall. In fact, this is not uncommon. If the deficit is small in a given year, than the addition to debt in the numerator of the debt/GDP ratio will be relatively small, while the growth in GDP is larger, and so the debt/GDP ratio declines. This was the experience of the U.S. economy for the period from the end of World War II to about 1980. It is also theoretically possible, although not likely, for a nation to have a budget surplus and see its debt/GDP ratio rise. Imagine the case of a nation with a small surplus, but in a recession year when the economy shrinks. It is possible that the decline in the nation's debt, in the numerator of the debt/GDP ratio, would be proportionally less than the fall in the size of GDP, so the debt/GDP ratio would rise.

a. Federal spending has grown substantially in recent decades. b. By world standards, the U.S. government controls a relatively large share of the U.S. economy. c. A majority of the federal government's revenue is collected through personal income taxes. d. Education spending is slightly larger at the federal level than at the state and local level. e. State and local government spending has not risen much in recent decades. f. Defense spending is higher now than ever. g. The share of the economy going to federal taxes has increased substantially over time. h. Foreign aid is a large portion, although less than half, of federal spending. i. Federal deficits have been very large for the last two decades. j. The accumulated federal debt as a share of GDP is near an all-time high.

a. As a share of GDP, this is false. In nominal dollars, it is true. b. False. c. False. d. False. Education spending is much higher at the state level. e. False. As a share of GDP, it is up about 50. f. As a share of GDP, this is false, and in real dollars, it is also false. g. False. h. False; it's about 1%. i. False. Although budget deficits were large in 2003 and 2004, and continued into the later 2000s, the federal government ran budget surpluses from 1998-2001. j. False.

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. A recession. b. A stock market collapse that hurts consumer and business confidence. c. Extremely rapid growth of exports. d. Rising inflation. e. A rise in the natural rate of unemployment. f. A rise in oil prices.

a. Expansionary, to stimulate demand. b. Expansionary, to stimulate demand. c. Contractionary, to fight inflation. d. Contractionary, to fight inflation e. 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. f. Expansionary, to stimulate demand.