GS ECO 2301 CH 16 Fiscal Policy

The first beneficiary was a legal secretary named Ida May Fuller. She worked for three years after the program began and paid total taxes of only $24.75.

During her retirement, she collected $22,888.92 in benefits.

How Large Are Supply-Side Effects? Most economists would agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labor supplied, cutting the corporate income tax will increase investment spending, and so on. The magnitude of the effects is the subject of considerable debate, however.

For example, some economists argue that the increase in the quantity of labor supplied following a tax cut will be limited because many people work a number of hours set by their employers and lack the opportunity to work additional hours. Similarly, some economists believe that tax changes have only a small effect on saving and investment. In this view, saving and investment are affected much more by changes in income or changes in expectations of the future profitability of new investment due to technological change or improving macroeconomic conditions than they are by changes in taxes.

If the tax code were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. In addition to wasting resources, the complexity of the tax code may also distort the decisions households and firms make.

For example, the tax rate on dividends has clearly affected whether corporations pay dividends. When Congress passed a reduction in the tax on dividends in 2003, many firms—including Microsoft—began paying dividends for the first time. A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments.

automatic stabilizers

Government spending and taxes that automatically increase or decrease along with the business cycle The word automatic indicates that changes in these types of spending and taxes happen without actions by the government. For example, 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.

A Summary of How Fiscal Policy Affects Aggregate Demand Table 16.1 summarizes how countercyclical fiscal policy affects aggregate demand. Just as we did with monetary policy, we must add a very important qualification to this summary of fiscal policy: The table isolates the effect of fiscal policy by holding constant monetary policy and all other factors affecting the variables involved.

In other words, we are again invoking the ceteris paribus condition we discussed in Chapter 3, Section 3.1. This point is important because, for example, in the actual economy, a contractionary fiscal policy does not cause the price level to fall. A contractionary fiscal policy causes the price level to rise by less than it would have risen without the policy.

Crowding Out 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. What is the long-run effect of a permanent increase in government spending?

In this case, 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. Recall that in the long run, real GDP returns to potential GDP (Chapter 13, Section 13.3).

We can look briefly at the effects on aggregate supply of cutting each of the following taxes: Individual income tax. As we have seen, 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. The profits of many partnerships are also 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. have these income pass-through businesses pay the corporate tax rate rather than the individual tax rate. If the corporate tax rate were also reduced, many sole proprietorships and partnerships would pay a lower tax rate on their profits. Most households are taxed on their returns from saving at the individual income tax rates. Reducing marginal income tax rates, therefore, also increases the return to saving.

Congress and the president intended the changes to federal expenditures and taxes from the stimulus package to be temporary. Figure 16.13 shows the effect of the stimulus package on federal government expenditures and revenue over time.

Panel (a) shows that the effect on federal government expenditures was greatest during 2010 and declined sharply during 2011. Panel (b) shows that the effect on federal government revenue was greatest during 2010 and had declined to almost zero by early 2011.

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. Together these factors will result in an increase in the quantity of real GDP supplied at every price level. We show the effects of the tax changes in Figure 16.16 by a shift in the long-run aggregate supply curve to LRAS3. With aggregate demand remaining unchanged, equilibrium moves from point A to point C (rather than to point B, which is the equilibrium without tax changes), with real GDP increasing from Y1 to Y3 and the price level decreasing from P1 to P3. Clearly, our analysis is unrealistic because we have ignored the changes that will occur in aggregate demand and short-run aggregate supply. How would a more realistic analysis differ from the simplified one in Figure 16.16? The change in real GDP would be the same because in the long run, real GDP is equal to its potential level, which is represented by the long-run aggregate supply curve. The outcome for the price level would be different, however, because we would expect both the aggregate demand curve and the short-run aggregate supply curve to shift to the right. The most likely outcome is that the price level would end up higher in the new equilibrium than in the original equilibrium.

Tax Simplification In addition to the potential gains from cutting individual taxes, there are also gains from tax simplification. 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, or about 45 hours per tax return. Households and firms have to deal with more than 480 tax forms to file their federal taxes and spend more than $10 billion per year to hire accountants to help fill out the forms. It is not surprising that there are more H&R Block offices around the country than there are Starbucks coffeehouses.

The Economic Effects of Tax Reform We can analyze the economic effects of tax reduction and simplification by using the aggregate demand and aggregate supply model. Figure 16.16 shows that without tax changes, the long-run aggregate supply curve will shift from LRAS1 to LRAS2.

This shift represents the increases in the labor force and the capital stock and the technological change that would occur even without tax reduction and simplification. To focus on the effect of tax changes on aggregate supply, we will ignore any shifts in the short-run aggregate supply curve, and we will assume that the aggregate demand curve remains unchanged, at AD1. In this case, equilibrium moves from point A to point B, with real GDP increasing from Y1 to Y2 and the price level decreasing from P1 to P2.

Remember that there is a difference between government purchases and government expenditures.

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. 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.

federal budget deficit

When the federal government spends more than it collects in taxes

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. The CBO forecast that in 2018, real GDP would equal potential GDP, so the values for the actual and cyclically adjusted budget deficits would also be equal.

Real federal government spending on national defense declined by

almost 25 percent between 1990 and 1998 and then rose by more than 60 percent between 1998 and 2010 in response to the war on terrorism and the wars in Iraq and Afghanistan. Defense spending declined more than 20 percent between 2010 and 2017 as those wars wound down.

Economists often measure government spending relative to the size of the economy by calculating government spending

as a percentage of GDP. As Figure 16.2 shows, federal government purchases as a percentage of GDP have actually been falling in most years since the end of the Korean War in the early 1950s.

discretionary fiscal policy

changes in federal taxes and purchases that are intended to achieve macroeconomic policy goals

Generally, the marginal tax rates on dividends and capital gains are still below the top marginal tax rate on

individual income. 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.

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."

Increasing the Growth Rate of Hours Worked. An increase in hours worked requires an increase in

population growth, an increase in the employment-population ratio, or an increase in hours worked per employee. Population growth increases only if birth rates increase, death rates decrease, or the rate of immigration increases.

Because long-run fiscal policy actions primarily affect aggregate supply rather than aggregate demand, they are

sometimes called supply-side economics.

In 2011, total federal expenditures were at their highest level as a percentage of GDP since

the end of World War II in 1945. In the following years, federal expenditures as a percentage of GDP declined again as a result of limits on spending enacted by Congress and the president.

A cut in taxes has an indirect effect on aggregate demand. Remember that

the income households have available to spend after they have paid their taxes is called disposable income (see Chapter 8, Section 8.4). Cutting the individual income tax will increase household disposable income and consumption spending. Cutting taxes on business income can increase aggregate demand by increasing investment spending.

The overview of fiscal policy we just finished contains a key idea: Congress and the president can use fiscal policy to affect aggregate demand, thereby changing the price level and the level of real GDP. The discussion of expansionary and contractionary fiscal policy illustrated by Figure 16.5 is simplified, however, because it ignores two important facts about the economy:

(1) The economy experiences continuing inflation, with the price level rising every year; and (2) the economy experiences long-run growth, with the LRAS curve shifting to the right every year.

Explaining Long-Run Increases in Real GDP The long-run growth rate of real GDP depends primarily on two factors:

1. The growth in the number of hours worked 2. The growth rate of labor productivity as measured by the growth in real GDP per hour worked We can explore the relationship between growth in real GDP and growth in these factors by noting that at any given time, as a matter of arithmetic, the following relationship must hold: Real GDP = Number of hours worked × (Real GDP / Number of hours worked)

In addition to purchases, there are three other categories of federal government expenditures:

1. interest on the national debt, Interest on the national debt represents payments to holders of the bonds the federal government has issued to borrow money. 2. grants to state and local governments, and Grants to state and local governments are payments made by the federal government to support government activity at the state and local levels. For example, to help reduce crime, Congress implemented a program of grants to local governments to hire more police officers. 3. transfer payments. The largest and fastest-growing category of federal expenditures is transfer payments. Some of these programs, such as Social Security and unemployment insurance, began in the 1930s. Others, such as Medicare, which finances health care for the elderly, and the food stamp (Supplemental Nutrition Assistance Program) and Temporary Assistance for Needy Families programs, which are intended to aid the poor, began in the 1960s or later.

A lively political debate has taken place over the future of the Social Security and Medicare programs. Some policymakers have proposed increasing taxes to fund future benefit payments. The tax increases needed, however, could be as much as

50 percent higher than current rates, and tax increases of that magnitude could discourage work effort, entrepreneurship, and investment, thereby slowing economic growth.

government purchases multiplier

= change in equilibrium real GDP / change in government purchases The ratio of the change in equilibrium real GDP to the initial change in government purchases If, for example, the government purchases multiplier has a value of 2, an increase in government purchases of $100 billion should increase equilibrium real GDP by 2 × $100 billion = $200 billion. We show this result in Figure 16.9 by having the cumulative increase in real GDP equal $200 billion.

During the Great Depression, workers who lost their jobs saw their wage income fall to zero and had to rely on their savings, what they could borrow, or what they received from private charities.

As a result, many unemployed workers drastically cut their spending, particularly on automobiles and other durable goods, which made the downturn worse.

Some economists argue that the federal government should normally run a deficit, even at potential GDP. When the federal budget is in deficit, the U.S. Treasury sells bonds to investors to raise the funds necessary to pay the government's bills.

Borrowing to pay the bills is a bad policy for a household, a firm, or the government when the bills are for current expenses, but it is not a bad policy if the bills are for long-lived capital goods. For instance, most families pay for a new home by taking out a 15- to 30-year mortgage. Because houses last many years, it makes sense to pay for a house out of the income the family makes over a long period of time rather than out of the income they receive in the year they bought the house.

fiscal policy

Changes in federal taxes and purchases that are intended to achieve macroeconomic policy goals

Currently, there are only 2.8 workers per retiree, and that ratio could decline to 2 workers per retiree by 2035.

Congress has attempted to deal with this problem by gradually raising the age to receive full benefits from 65 to 67 and by increasing payroll taxes.

American Recovery and Reinvestment Act of 2009 Although the tax rebates helped increase aggregate demand, we saw in Chapter 15, Section 15.6 that the recession worsened in September 2008, following the bankruptcy of the Lehman Brothers investment bank and the deepening of the financial crisis. President Obama took office in January 2009, pledging to pursue an expansionary fiscal policy.

Congress responded in February by passing the American Recovery and Reinvestment Act of 2009, often called the "stimulus package," an $840 billion program of spending increases and tax cuts that was by far the largest fiscal policy action in U.S. history. 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.

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. By contrast, the president and a majority of the 535 members of Congress have to agree on changes in fiscal policy. Even after a change in fiscal policy has been approved, it takes time to implement. Suppose Congress and the president agree to increase aggregate demand by spending $30 billion more on constructing subway systems in several cities. It will probably take at least several months to prepare detailed plans for the construction. Local governments will then ask for bids from private construction companies. Once the winning bidders have been selected, they will usually need several months to begin the project. Only then will significant amounts of spending actually take place. This delay may push the spending beyond the end of the recession that the spending was intended to fight.

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.

The Size of the Multiplier: A Key to Estimating the Effects of Fiscal Policy In preparing the values shown in Table 16.2, the CBO relied on estimates of the government purchases and tax multipliers. Economists have been debating the size of these multipliers for many years.

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.

The greater the sensitivity of consumption, investment, and net exports to changes in interest rates, the more crowding out will occur. In a deep recession, many firms may be pessimistic about the future and have so much excess capacity that investment spending will fall to very low levels and will be unlikely to fall much further, even if interest rates rise. In this case, crowding out is unlikely to be a problem. If the economy is close to potential GDP, however, and firms are optimistic about the future, an increase in interest rates may result in a significant decline in investment spending.

Figure 16.12 shows that crowding out may reduce the effectiveness of an expansionary fiscal policy. Short-run equilibrium is initially at point A, with real GDP at $16.8 trillion. Real GDP is below potential GDP, so the economy is in a recession. Suppose that Congress and the president decide to increase government purchases to increase real GDP to potential GDP. In the absence of crowding out, the increase in government purchases will shift the aggregate demand curve to AD2(no crowding out), and equilibrium will be at point B, with real GDP equal to potential GDP of $17.0 trillion. But the higher interest rate resulting from the increased government purchases will reduce consumption, investment, and net exports, causing the aggregate demand curve to shift back to AD2(crowding out). The result is a new short-run equilibrium at point C, with real GDP of $16.9 trillion, which is $100 billion short of potential GDP. (Note that the price level increase shown in Figure 16.10 also contributes to reducing the effect of an increase in government purchases on equilibrium real GDP.)

To briefly review the dynamic model, recall that over time, potential GDP increases, which we show by shifting the LRAS curve to the right. The factors that cause the LRAS curve to shift also cause firms to supply more goods and services at any given price level in the short run, which we show by shifting the SRAS curve to the right.

Finally, during most years, the aggregate demand curve also shifts to the right, indicating that aggregate expenditure is higher at every price level.

Deficits occur automatically during recessions for two reasons:

First, during a recession, wages and profits fall, causing government tax revenues to fall. Second, the government automatically increases its spending on transfer payments when the economy moves into a recession. The federal government's contributions to the unemployment insurance program will increase as unemployment rises. Spending will also increase on programs to aid low-income people, such as the food stamp, Temporary Assistance for Needy Families, and Medicaid programs. These spending increases take place without Congress and the president taking any action. Existing laws already specify who is eligible for unemployment insurance and these other programs. As the number of eligible persons increases during a recession, so does government spending on these programs.

The Social Security program began as a "pay-as-you-go" system, meaning that payments to current retirees were made with taxes collected from current workers. In the early years of the program, many workers were paying into the system, and there were relatively few retirees.

For example, in 1940, more than 35 million workers were paying into the system, and only 222,000 people were receiving benefits—a ratio of more than 150 workers to each retiree. In those early years, most retirees received far more in benefits than they had paid in taxes.

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.

For example, in 2010, the unemployment rate was 9.6 percent, which was far above the unemployment rate of 4.6 percent in 2007. According to the CBO, without the stimulus package, the unemployment rate would have been somewhere between 10.0 percent and 11.4 percent. So, the stimulus package reduced the increase in the unemployment rate that might otherwise have occurred, but it did not come close to bringing the economy back to full employment.

When economists forecast future growth rates of real GDP, they first have to forecast trends in these other variables.

For example, in 2017, the CBO forecast that real GDP would grow at an average annual rate of 1.9 percent for the years 2017-2027. Table 16.4 summarizes how the CBO arrived at this estimate. Note that the CBO believes that the growth in hours worked will be much slower than population growth, for the reasons given in the table.

Figure 16.14 also shows the effects on the federal budget deficit of the Obama administration's $840 billion stimulus package and the severity of the 2007-2009 recession.

From 2009 through 2011, the federal budget deficit was greater than 8 percent of GDP, which was the first time in the history of the country that the deficit had been this large except during major wars. The economic recovery combined with tax increases and reductions in federal spending resulted in the deficit being about 3 percent of GDP in 2017.

When we discussed the quantity theory of money in Chapter 14, Section 14.5, we noted the mathematical rule that an equation in which variables are multiplied together is equal to an equation in which the growth rates of these variables are added together. Therefore, we can say that:

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. The faster the growth rate of the population, the faster the number of hours worked will increase, but only if the employment-population ratio and the average number of hours worked remain constant or increase. A decline in either the employment-population ratio or in average hours worked can cause the growth rate of hours worked to lag behind the population growth rate. When economists forecast future growth rates of real GDP, they first have to forecast trends in these other variables.

When GDP increases above its potential level, households and firms have to pay more taxes to the federal government, and the federal government makes fewer transfer payments.

Higher taxes and lower transfer payments cause total spending to rise by less than it otherwise would have, which helps reduce the chance that the economy will experience higher inflation.

Crowding Out in the Long Run (continued) Suppose that real GDP currently equals potential GDP and that government spending is 35 percent of GDP. In that case, private expenditures—the sum of consumption, investment, and net exports—will make up the other 65 percent of GDP.

If government spending is increased permanently to 37 percent of GDP, in the long run, private expenditures must fall to 63 percent of 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.

The federal government's three largest transfer programs are Social Security, Medicare, and Medicaid.

In 1935, Congress and President Franklin Roosevelt established the Social Security program to make payments to retired and disabled workers. In 1965, Congress and President Lyndon Johnson established the Medicare program to provide health care coverage to people age 65 and over, and the Medicaid program to help state governments provide medical care to low-income people.

The long-term financial situation for Medicare is an even greater cause for concern than is Social Security. As Americans live longer and as new—and expensive—medical procedures are developed, the projected expenditures under the Medicare program will eventually far outstrip projected tax revenues. The federal government also faces increasing expenditures under the Medicaid program, which was substantially expanded when Congress passed the Patient Protection and Affordable Care Act (ACA) in 2010.

In 2017, federal spending on Social Security, Medicare, and Medicaid equaled 10.4 percent of GDP. Spending on these three programs was less than 3 percent of GDP in 1962. The Congressional Budget Office (CBO) forecasts that federal spending on these three programs will rise to 14.9 percent of GDP in 2040, 16.2 percent by 2060, and 19.7 percent by 2090. The following graph illustrates these forecasts.

Federal government purchases can be divided into two categories: defense spending—which makes up 17.6 percent of the federal budget—and spending on everything else the federal government does—from paying the salaries of FBI agents, to operating the national parks, to supporting scientific research—which makes up 8.6 percent of the budget.

In addition to purchases, there are three other categories of federal government expenditures: interest on the national debt, grants to state and local governments, and transfer payments. Transfer payments rose from 25 percent of federal government expenditures in the 1960s to 49.2 percent in 2016. Source: U.S. Bureau of Economic Analysis.

Automatic budget surpluses and deficits can help stabilize the economy. When the economy moves into a recession, wages and profits fall, reducing the taxes that households and firms owe the government.

In effect, households and firms have received an automatic tax cut that keeps their spending higher than it otherwise would have been. In a recession, workers who have been laid off receive unemployment insurance payments, and households whose incomes have fallen below a certain level become eligible for food stamps and other government transfer programs. By receiving this extra income, households are able to spend more than they otherwise would have spent. The extra spending helps reduce the length and severity of the recession. Many economists argue that the lack of an unemployment insurance system and other government transfer programs contributed to the severity of the Great Depression.

How Can We Measure the Effectiveness of the Stimulus Package? At the time the stimulus package was passed, economists working for the Obama administration estimated that the increase in aggregate demand resulting from the package would increase real GDP by 3.5 percent by the end of 2010 and increase employment by 3.5 million.

In fact, between the beginning of 2009 and the end of 2010, real GDP increased by 4.0 percent, while employment declined by 3.3 million. Do these results indicate that the stimulus package was successful in increasing GDP but not employment? We have to be careful in drawing that conclusion. 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. In other words, the actual movements in real GDP and employment are a mixture of the effects of the stimulus package and the effects of other factors, such as the Federal Reserve's monetary policy and the typical changes in real GDP and employment during a business cycle that occur independently of government policy.

How the Federal Budget Can Serve as an Automatic Stabilizer Discretionary fiscal policy can increase the federal budget deficit during recessions by increasing spending or cutting taxes to increase aggregate demand.

In many milder recessions, though, no significant discretionary fiscal policy actions are taken. In fact, 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 we mentioned in Section 16.1.

In the hypothetical situation shown in Figure 16.6, equilibrium is initially at point A, with real GDP equal to potential GDP of $17.0 trillion and the price level equal to 110. In the second year, LRAS increases to $17.4 trillion, but aggregate demand increases only from AD1 to AD2(without policy), which is not enough to keep real GDP equal to potential GDP.

Let's assume that the Fed does not react to the situation with an expansionary monetary policy. In that case, short-run equilibrium will occur at point B, with real GDP of $17.3 trillion and a price level of 113. The $100 billion gap between real GDP and potential GDP means that some firms are operating at less than their full capacity. Incomes and profits will be falling, firms will begin to lay off workers, and the unemployment rate will increase. Increasing government purchases or cutting taxes can shift aggregate demand to AD2(with policy). Equilibrium will be at point C, with real GDP of $17.4 trillion, which is its potential level, and a price level of 115. The price level is higher than it would have been without an expansionary fiscal policy.

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. As we discussed previously, crowding out of investment spending may occur if increasing debt drives up interest rates.

Lower investment spending means a lower capital stock in the long run and a reduced capacity of the economy to produce goods and services. This effect is somewhat offset if some of the government debt was incurred to finance improvements in infrastructure, such as bridges, highways, and ports; to finance education; or to finance research and development. Improvements in infrastructure, a better-educated labor force, and additional research and development can add to the productive capacity of the economy.

In 2008, at the urging of President Bush, Congress enacted a tax cut that took the form of rebates of taxes that households had already paid. Rebate checks totaling $95 billion were sent to taxpayers between April and July 2008. How effective were the rebates in increasing consumption spending?

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. For example, a medical student may have very low current income but a high expected future income. The student may borrow against this high expected future income rather than having to consume at a very low level in the present.

Figure 16.5 shows the results of an expansionary fiscal policy, using the basic aggregate demand and aggregate supply model. In this model, there is no economic growth, so the long-run aggregate supply (LRAS) curve does not shift.

Notice that this figure is very similar to Figure 16.7, which shows the effects of an expansionary monetary policy. The goal of both expansionary monetary policy and expansionary fiscal policy is to increase aggregate demand relative to what it would have been without the policy. (a) Expansionary fiscal policy (b) Contractionary fiscal policy In panel (a), short-run equilibrium is at point A, with real GDP of $16.8 trillion and a price level of 108. Real GDP is below potential GDP, so the economy is in a recession. An expansionary fiscal policy will cause aggregate demand to shift to the right, from AD1 to AD2, increasing real GDP from $16.8 trillion to $17.0 trillion and the price level from 108 to 110 (point B). In panel (b), short-run equilibrium is at point A, with real GDP at $17.2 trillion and the price level at 112. Because real GDP is greater than potential GDP, the economy will experience rising wages and prices. A contractionary fiscal policy will cause aggregate demand to shift to the left, from AD1 to AD2, decreasing real GDP from $17.2 trillion to $17.0 trillion and the price level from 112 to 110 (point B).

We can conclude that Congress and the president can attempt to stabilize the economy by using fiscal policy to affect the price level and the level of real GDP.

Of course, in practice 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.

Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation. In Figure 16.7, equilibrium is initially at point A, with real GDP equal to potential GDP of $17.0 trillion and the price level equal to 110.

Once again, LRAS increases to $17.4 trillion in the second year. In this scenario, the shift in aggregate demand to AD2(without policy) results in a short-run macroeconomic equilibrium at point B, with real GDP of $17.5 trillion, which is greater than potential GDP. If we assume that the Fed does not respond to the situation with a contractionary monetary policy, the economy will experience a rising inflation rate. Decreasing government purchases or increasing taxes can keep real GDP from moving beyond its potential level. The result, shown in Figure 16.7, is that in the new equilibrium at point C, the inflation rate, measured by the percentage change in the price level, is 2.7 percent rather than 4.5 percent.

We can look briefly at the effects on aggregate supply of cutting each of the following taxes: Taxes on dividends and capital gains. 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.

Rising profits usually result in rising stock prices and capital gains to shareholders. Individuals pay taxes on both dividends and capital gains (although the tax on capital gains can be postponed if the stock is not sold). As a result, the same earnings are, in effect, taxed twice: 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. With the corporate income tax remaining in place, one way to reduce the "double taxation" problem is to reduce the tax rates on dividends and capital gains. These rates were reduced in 2003 and then increased in 2013.

When discussing the model of demand and supply in Chapter 3, we saw that increasing the price of a good or service increases the quantity supplied. So, we would expect that reducing the tax wedge by cutting the marginal tax rate on income would result in a larger quantity of labor supplied because the posttax wage would be higher.

Similarly, we saw in Chapter 10, Section 10.2 that a reduction in the income tax rate would increase the posttax return to saving, causing an increase in the supply of loanable funds, a lower equilibrium interest rate, and an increase in investment spending. In general, economists believe that the smaller the tax wedge for any economic activity—such as working, saving, investing, or starting a business—the more of that economic activity that will occur. 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.

Before the Great Depression of the 1930s, the majority of government spending in the United States took place at the state and local levels. As Figure 16.1 shows, the size of the federal government expanded significantly during the crisis of the Great Depression.

Since World War II, the federal government's share of total government expenditures has been between two-thirds and three-quarters.

Tax cuts also have a multiplier effect because they increase the disposable income of households. When household disposable income rises, so will consumption spending. These increases in consumption spending will set off further increases in real GDP and income, just as increases in government purchases do.

Suppose we consider a change in taxes of a specific amount—say, a tax cut of $100 billion—with the tax rate remaining unchanged. The expression for this tax multiplier is: Tax multiplier = Change in equilibrium real GDP / Change in taxes The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions: An increase in taxes reduces disposable income, consumption, and real GDP, and a decrease in taxes raises disposable income, consumption, and real GDP. For example, if the tax multiplier is −1.6, a $100 billion cut in taxes will increase real GDP by −1.6 × (−$100 billion) = $160 billion.

Businesses often borrow the funds to buy machinery, equipment, and factories by selling 30-year corporate bonds. Because these capital goods generate profits for the businesses over many years, it makes sense to pay for them over a period of years as well. By similar reasoning, when the federal government contributes to the building of a new highway, bridge, or subway, it may want to borrow funds by selling Treasury bonds.

The alternative is to pay for these long-lived capital goods out of the tax revenues received in the year the goods were purchased. But that means that the taxpayers in that year have to bear the whole burden of paying for the projects, even though taxpayers for many years in the future will be enjoying the benefits.

Because budget deficits automatically increase during recessions and decrease during expansions, economists often look at the cyclically adjusted budget deficit or surplus, which can 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.

The cyclically adjusted budget deficit or surplus measures what the deficit or surplus would be if real GDP were at potential GDP. For example, the federal budget deficit in 2009 was 9.2 percent of GDP. The CBO estimates that if real GDP had been at its potential level, the deficit would have been about 7.1 percent of GDP, with the remaining 2.1 percent representing the increase in the deficit due to the effects of automatic stabilizers.

Total federal expenditures as a percentage of GDP rose from 1950 to the early 1990s and then fell from 1992 to 2000, before rising again.

The decline in expenditures between 1992 and 2001 was partly the result of the end of the Cold War between the Soviet Union and the United States, which allowed for a substantial reduction in defense spending.

Is Government Debt a Problem? Debt can be a problem for a government for the same reasons it can be a problem for a household or a business. If a family has difficulty making the monthly mortgage payment, it will have to cut back spending on other goods and services. If the family is unable to make the payments, it will have to default on the loan and will probably lose its house.

The federal government is not in danger of defaulting on its debt. Ultimately, the government can raise the funds it needs through taxes to make the interest payments on the debt. 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. At this level, tax increases or significant cutbacks in other types of federal spending are not required.

Figure 16.6 shows the results of an expansionary fiscal policy using the dynamic aggregate demand and aggregate supply model. Notice that this figure is very similar to Figure 15.9, which showed the effects of an expansionary monetary policy.

The goal of both expansionary monetary policy and expansionary fiscal policy is to increase aggregate demand relative to what it would have been without the policy.

Figure 16.15 shows federal government debt as a percentage of GDP in the years from 1790 to 2017, with the CBO's forecasts through the year 2047. The ratio of debt to GDP increased during the American Revolution, the Civil War, World Wars I and II, and the Great Depression, reflecting the large government budget deficits of those years.

The large deficits beginning in 2008 caused the ratio to rise above 100 percent of GDP for the first time since 1947. The CBO forecasts that if federal expenditures and revenues continue on their projected course, federal government debt will reach a record level of 150 percent of GDP in 2047.

Figure 16.8 illustrates how an increase in government purchases affects the aggregate demand curve. The initial increase causes the aggregate demand curve to shift to the right because total spending in the economy is now higher at every price level.

The shift to the right from AD1 to the dashed AD curve represents the effect of the initial increase of $100 billion in government purchases. Because this initial increase in government purchases raises incomes and leads to further increases in consumption spending, the aggregate demand curve will ultimately shift from AD1 all the way to AD2.

Figure 16.4 shows that in 2016, the federal government raised 44.3 percent of its revenue from individual income taxes. Payroll taxes to fund the Social Security and Medicare programs raised 35.2 percent of federal revenues.

The tax on corporate profits raised 12.7 percent of federal revenues. The remaining 7.8 percent of federal revenues were raised from excise taxes on certain products, such as cigarettes and gasoline, from tariffs on goods imported from other countries, from payments by the Federal Reserve from its profits on its security holdings, and from other sources, such as payments by companies that cut timber on federal lands.

As Table 16.3 shows, economists' estimates of the size of the multiplier vary widely.

The uncertainty about the size of the multiplier indicates the difficulty that economists have in arriving at a firm estimate of the effects of fiscal policy.

Crowding Out in the Short Run Consider the case of a temporary increase in government purchases. Suppose the federal government decides to fight a recession by spending $30 billion more this year on repairs to the Interstate Highway System. When the $30 billion has been spent, the program will end, and government purchases will drop back to their previous level. As the spending takes place, income and real GDP will increase.

These increases in income and real GDP will cause households and firms to increase their demand for currency and checking account balances to accommodate the increased buying and selling. Figure 16.11 shows the result, using the money market graph introduced in Chapter 15, Section 15.2. An increase in government purchases will increase the demand for money from Money demand1 to Money demand2 as real GDP and income rise. With the supply of money constant, at $3.5 trillion, the result is an increase in the equilibrium interest rate from 3 percent to 4 percent, which crowds out some consumption, investment, and net exports.

In panel (a) of Figure 16.5, short-run equilibrium occurs at point A, where the aggregate demand (AD1) curve intersects the short-run aggregate supply (SRAS) curve. Real GDP is below potential GDP, so the economy is in a recession, with some firms operating below normal capacity and some workers having been laid off.

To bring real GDP back to potential GDP, Congress and the president increase government purchases or cut taxes, which will shift the aggregate demand curve to the right, from AD1 to AD2. Real GDP increases from $16.8 trillion to potential GDP of $17.0 trillion, and the price level rises from 108 to 110 (point B). The policy has successfully returned real GDP to its potential level. Rising production will lead to increasing employment, reducing the unemployment rate.

Taking into Account the Effects of Aggregate Supply To this point, as we discussed the multiplier effect, we assumed that the price level was constant. We know, though, that because the SRAS curve is upward sloping, when the AD curve shifts to the right, the price level will rise. As a result of the rise in the price level, equilibrium real GDP will not increase by the full amount that the multiplier effect indicates. Figure 16.10 illustrates how an upward-sloping SRAS curve affects the size of the multiplier.

To keep the graph relatively simple, we assume that the SRAS and LRAS curves do not shift. Short-run equilibrium is initially at point A, with real GDP below its potential level. An increase in government purchases shifts the aggregate demand curve from AD1 to the dashed AD curve. Just as in Figure 16.8, the multiplier effect causes a further shift in the aggregate demand curve, to AD2. If the price level remained constant, real GDP would increase from $16.8 trillion at point A to $17.2 trillion at point B. However, because the SRAS curve is upward sloping, the price level rises from 110 to 113, reducing the total quantity of goods and services demanded in the economy. The new equilibrium occurs at point C, with real GDP having risen to $17.0 trillion, or by $200 billion less than if the price level had remained unchanged. We can conclude that the actual change in real GDP resulting from an increase in government purchases or a cut in taxes will be less than that indicated by the simple multiplier effect with a constant price level.

Table 16.2 shows estimates from economists at the CBO of the effectiveness of the stimulus package. The CBO is a nonpartisan organization, and many economists believe its estimates are reasonable. But 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. For example, in the absence of the stimulus package, the CBO estimates that in 2010, between 0.9 million and 4.7 million fewer people would have been employed than actually were, and the unemployment rate would have been between 0.4 percent and 1.8 percentage points higher than it actually was. 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.

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 see why economists take this view, consider what the federal government would have to do to keep the budget balanced during a recession, when the budget automatically moves into deficit. 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. Similarly, when GDP increases above its potential level, the budget automatically moves into surplus. To eliminate this surplus, the government would have to cut taxes or increase government spending. But these actions would increase aggregate demand, thereby pushing GDP further beyond potential GDP and increasing the risk of higher inflation. To balance the budget every year, the government might have to take actions that would destabilize the economy.

The Effect of Changes in the Tax Rate A change in the tax rate has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. To begin with, the value of the tax rate affects the size of the multiplier effect. The higher the tax rate, the smaller the multiplier effect.

To see why, think about the size of the additional spending increases that take place in each period following an increase in government purchases. The higher the tax rate, the smaller the amount of any increase in income that households have available to spend, which reduces the size of the multiplier effect. So, a cut in the tax rate affects equilibrium real GDP through two channels: (1) A cut in the tax rate increases the disposable income of households, which leads them to increase their consumption spending, and (2) a cut in the tax rate increases the size of the multiplier effect.

Don't Confuse Fiscal Policy and Monetary Policy If you keep in mind the definitions of money, income, and spending, the difference between monetary policy and fiscal policy will be clearer. Students often make these two related mistakes: (1) They think of monetary policy as the Federal Reserve fighting recessions by increasing the money supply so people will have more money to spend; and (2) they think of fiscal policy as Congress and the president fighting recessions by spending more money. In this view, the only difference between fiscal policy and monetary policy is the source of the money.

To understand what's wrong with the descriptions of fiscal policy and monetary policy just given, first remember that the problem during a recession is not that there is too little money—currency plus checking account deposits—but too little spending. The purpose of expansionary monetary policy is to lower interest rates, which in turn increases aggregate demand. When interest rates fall, households and firms are willing to borrow more to buy cars, houses, and factories. The purpose of expansionary fiscal policy is to increase aggregate demand by: 1. Having the government directly increase its own purchases, or 2. Cutting income taxes to increase household disposable income and, therefore, consumption spending, or 3. Cutting business taxes to increase investment spending Just as increasing or decreasing the money supply does not have a direct effect on government spending or taxes, increasing or decreasing government spending or taxes does not have a direct effect on the money supply. Fiscal policy and monetary policy have the same goals, but they attempt to reach those goals in different ways.

How Can Fiscal Policy Affect Long-Run Economic Growth? The Long-Run Effects of Tax Policy 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. Regulatory reform has the potential both to increase the size of the labor force and, therefore, employment, and to increase labor productivity.

We can look more closely at the effect of tax changes on real GDP growth. The difference between the pretax and posttax return to an economic activity is called the tax wedge. It is determined by the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes.

To better understand the multiplier effect, let's start with a simplified analysis in which we assume that the price level is constant. In other words, initially we will ignore the effect of an upward-sloping SRAS curve. Figure 16.9 shows how spending and real GDP increase over a number of periods, beginning with the initial increase in government purchases in the first period, which raises real GDP and total income in the economy by $100 billion. How much additional consumption spending will result from $100 billion in additional income?

We know that while increasing their consumption spending on domestically produced goods, households will also save some of the increase in income, use some to pay income taxes, and use some to purchase imported goods, which will have no direct effect on spending and production in the U.S. economy. In Figure 16.9, we assume that in the second period, households increase their consumption spending by half the increase in income from the first period—or by $50 billion. This consumption spending in the second period will, in turn, increase real GDP and income by an additional $50 billion. In the third period, consumption spending will increase by $25 billion, or half the $50 billion increase in income from the second period.

The Federal Government Debt Every time the federal government runs a budget deficit, the Treasury must borrow funds from investors by selling Treasury securities. For simplicity, we will refer to all Treasury securities as "bonds."

When the federal government runs a budget surplus, the Treasury pays off some existing bonds. Figure 16.14 shows that there are many more years of federal budget deficits than years of federal budget surpluses. As a result, the total number of Treasury bonds outstanding has grown over the years.

Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation. In panel (b) of Figure 16.5, short-run equilibrium occurs at point A, with real GDP of $17.2 trillion, which is above potential GDP of $17.0 trillion.

With some firms producing beyond their normal capacity and the unemployment rate very low, wages and prices will be increasing. To bring real GDP back to potential GDP, Congress and the president decrease government purchases or increase taxes, which will shift the aggregate demand curve to the left, from AD1 to AD2. Real GDP falls from $17.2 trillion to $17.0 trillion, and the price level falls from 112 to 110 (point B).

The Board of Trustees of the Social Security Administration forecasts that through 2090, the gap between the benefits projected to be paid under the Social Security and Medicare programs and projected tax revenues is

a staggering $11.4 trillion measured in present value terms (present value calculations are explained in the appendix to Chapter 6), or more than half the value of GDP in 2017. If current projections are accurate, policymakers are faced with the choice of significantly restraining spending on these programs, greatly increasing taxes on households and firms, or implementing some combination of spending restraints and tax increases.

In response to the recession of 2007-2009, Congress and President Obama attempted to increase aggregate demand by enacting the American Recovery and Reinvestment Act (ARRA) of 2009, which

authorized a $500 billion increase in federal spending. The spending fell into several categories, including spending on infrastructure projects such as rebuilding the Doyle Drive approach to the Golden Gate Bridge in San Francisco.

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.

We can look briefly at the effects on aggregate supply of cutting each of the following taxes: Corporate income tax. The federal government taxes the profits corporations earn under the corporate income tax. In 2017, most corporations faced a marginal corporate tax rate of 35 percent, which is higher than the rate in any other high-income country.

cutting the marginal corporate income tax rate to 20 percent to encourage investment spending by increasing the return corporations receive from new investments in equipment, factories, and office buildings. Because innovations are often embodied in new investment goods, cutting the corporate income tax can potentially increase the pace of technological change. 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.

Poorly timed fiscal policy, like poorly timed monetary policy, can

do more harm than good. As we discussed in Chapter 15, Section 15.3, it takes time for policymakers to collect statistics and identify changes in the economy. If the government decides to increase spending or cut taxes to fight a recession that is about to end, the effect may be to increase the inflation rate. Similarly, cutting spending or raising taxes to slow down an economy that has actually already moved into a recession can increase the length and depth of the recession.

Figure 16.3 shows that in 2016, transfer payments were 49.2 percent of federal government expenditures, having nearly

doubled since the 1960s, when they were only 25 percent of federal government expenditures. As the U.S. population ages and medical costs continue to increase, federal government spending on the Social Security and Medicare programs will continue to rise, causing transfer payments to consume an increasing share of federal expenditures.

As we saw in Chapter 15, the Federal Reserve's Federal Open Market Committee meets

eight times per year to decide whether to change monetary policy. Less frequently, Congress and the president also make changes in taxes and government purchases to achieve macroeconomic policy goals, such as high employment, price stability, and high rates of economic growth.

For example, a decision to cut the taxes of people who buy electric cars is an

environmental policy action, not a fiscal policy action. Similarly, the spending increases to fund the war on terrorism and the wars in Iraq and Afghanistan were part of defense and homeland security policy, not fiscal policy.

When the economy is in a recession,

increases in government purchases or decreases in taxes will increase aggregate demand. As we saw in Chapter 13, the inflation rate may increase when real GDP is beyond potential GDP. Decreases in government purchases or increases in taxes can slow the growth of aggregate demand and reduce the inflation rate. These short-run policies are also called countercyclical policies because Congress and the president intend them to offset the effects of the business cycle.

Expansionary fiscal policy involves

increasing government purchases or decreasing taxes. An increase in government purchases will increase aggregate demand directly because government purchases are a component of aggregate demand.

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.

Monetary policy typically tries to

offset the effects of the business cycle on output and employment and to achieve a low rate of inflation in the long run. The Federal Reserve carries out monetary policy through changes in interest rates and the money supply.

Fiscal policy can also be aimed at

offsetting the effects of the business cycle. But, as we saw in the chapter opener, fiscal policy also has the potential to affect the economy's long-run growth rate. 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.

One-time tax rebates, such as the one in 2008, increase consumers' current income but not their permanent income. Only a

permanent decrease in taxes increases consumers' permanent income. Therefore, a tax rebate is likely to increase consumption spending less than would a permanent tax cut. Some estimates of the effect of the 2008 tax rebate, including studies by Christian Broda of the University of Chicago and Jonathan Parker of Northwestern University, and by economists at the Congressional Budget Office, indicate that taxpayers spent between 33 and 40 percent of the rebates they received. Taxpayers who have difficulty borrowing against their future income increased their consumption the most. The 2008 tax rebates totaled $95 billion, so consumers may have increased their spending by about $35 billion.

Figure 16.3 shows that spending on most of the federal government's day-to-day activities—including running federal agencies

such as the Environmental Protection Agency, the Federal Bureau of Investigation, the National Park Service, and the Immigration and Naturalization Service—makes up only 8.6 percent of federal government expenditures.

With discretionary fiscal policy, the government

takes actions to change spending or taxes.

Economists typically use the term fiscal policy to refer only to

the actions of the federal government. 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.

We would expect the tax multiplier to be smaller in absolute value than the government purchases multiplier. To see why, think about

the difference between a $100 billion increase in government purchases and a $100 billion decrease in taxes. 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. The fraction of the tax cut that households save or spend on imports will not increase aggregate demand. Therefore, the first period of the multiplier process will involve a smaller increase in aggregate demand than occurs when there is an increase in government purchases, and the total increase in equilibrium real GDP will be smaller.

budget deficit

the federal government's expenditures are greater than its tax revenue

budget surplus

the federal government's expenditures are less than its tax revenue

multiplier effect

the series of induced increases in consumption spending that results from an initial increase in autonomous expenditures

Does Government Spending Reduce Private Spending? Even if Congress and the president correctly time fiscal policy, they may face another problem. We have been assuming that when the federal government increases its purchases by $30 billion, the multiplier effect will cause the increase in aggregate demand to be greater than $30 billion. However,

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.

As with many other macroeconomic variables, it is useful to consider the size of the surplus or deficit relative to

the size of the overall economy. Figure 16.14 shows that, as a percentage of GDP, the largest deficits of the twentieth century came during World Wars I and II. During major wars, higher taxes only partially offset massive increases in government expenditures, leaving large budget deficits. During recessions, government spending increases and tax revenues fall, increasing the budget deficit. In 1970, the federal government entered a long period of continuous budget deficits. From 1970 through 1997, the federal government's budget was in deficit every year. From 1998 through 2001, there were four years of budget surpluses. The recessions of 2001 and 2007-2009, tax cuts, and increased government spending on homeland security and the wars in Iraq and Afghanistan helped keep the budget in deficit in the years after 2001.

Between 1950 and 2016, real GDP grew at an average annual rate of 3.1 percent. But between 2007 and 2016

this growth rate had slowed dramatically to only 1.3 percent. In early 2017, the Congressional Budget Office forecast that real GDP growth from 2017-2027 would increase only to 1.8 percent, and most economic forecasters agreed that in the absence of new policies, the growth rate of real GDP was unlikely to return to 3 percent.

Consistent with Reinhart and Rogoff's findings that recessions following financial crises tend to be

unusually severe, the 2007-2009 recession was the worst in the United States since the Great Depression of the 1930s. The recession lasted nearly twice as long as the average of earlier postwar recessions, GDP declined by more than twice the average, and the peak unemployment rate was about one-third higher than the average. While some economists argue that better monetary or fiscal policies might have shortened the recession and made it less severe, most economists agree that the financial crisis plays a key role in explaining the severity of the 2007-2009 recession.