Chapter 29 Macroeconomics- Fiscal Policy

Macroeconomics Chapter 29: Fiscal Policy Fiscal Policy: use of government budget tools, spending, and taxes to influence the macroeconomy Expansionary Fiscal Policy • Expansionary fiscal policy: occurs when the government increases spending or decreases taxes to stimulate the economy toward expansion • In theory, the economy can move itself back to full employment in the long run when all prices adjust • Fiscal policy can make use of government spending, taxes, or a combination of the two. • Increases in government spending increases aggregate demand o When private spending (consumption, investment, and net exports) is low, the government can increase demand by increasing their spending • Fiscal policy can decrease taxes to increase consumption o Decreasing taxes increases aggregate demand • Budget deficits o the government pays for all the spending or copes with the shortfall in tax revenue through borrowing o 80% of U.S. tax revenue derives from payroll taxes o with income down and unemployment up, the amount of revenue that the government takes in from taxes falls, even if the tax rate stays the same. (recession) o expansionary fiscal policy leads to increases in budget deficits and the national debt • It might work because spending by one person is earning by another and hopefully it would snowball? Fiscal Policy in the Great Recession • In February 2008, President Bush signed the Economic Stimulus Act of 2008, which introduced tax cuts to stimulate the economy and avoid recession. • But during 2008, the economy sunk deeper into recession. • In February 2009, President Obama signed the American Recovery and Reinvestment Act of 2009, which focused on government spending programs. Contractionary Fiscal Policy • Contractionary fiscal policy: when the government decreases spending or increases taxes to slow economic expansion • Expansionary policy creates deficits but contractionary fiscal policy reduces the deficit and pays off debt • the government might want to reduce aggregate demand if it believes that the economy is expanding beyond its long-run capabilities • if the unemployment rate falls below the natural rate (u*), output may be above Y*, some economists worry the economy will “overheat” from too much spending • moves the economy from short-run equilibrium at point a to equilibrium at point B, thus avoiding the inflationary outcome at point C. Countercyclical Fiscal Policy • Countercyclical fiscal policy: seeks to counteract business cycle fluctuations with expansionary policy during economic downturns and contractionary policy during economic expansions • Founded in Keynesian economics Multipliers • what one person spends becomes income to others • increases in income generally lead to increases in consumption • marginal propensity to consume (MPC): the portion of additional income that is spent on consumption • MPC=change in consumption/change in income • The multiplier effect is significant when we focus on aggregate demand in the economy. Each time people earn new income, they spend part of it. After all the dust settles, the total impact is a multiple of the original spending created by the fiscal policy. • Spending increases > aggregate demand increases • Spending multiplier: total impact on spending from an initial change of a given amount o the greater the marginal propensity to consume, the greater the spending multiplier o m=1/(1-MPC) Shortcomings of Fiscal Policy • Time lags o Recognition lag: difficult to recognize when expansion or contraction starts. ▪ Ex: one bad month might not mean a recession, unemployment data lags, final estimates for quarters aren’t known until months later o Implementation lag: it takes time to implement fiscal policy ▪ Ex: Governing bodies have to approve taxes and legislation o Impact lag: takes time for the complete effects of fiscal or monetary policy to materialize. ▪ The multiplier makes fiscal policy powerful, but it takes time to ripple through the economy. o Automatic stabilizers: government programs that automatically implement countercyclical fiscal policy in response to economic conditions (can eliminate recognition and implementation lags) ▪ Progressive income tax rates guarantee that individual tax bills fall when incomes fall (during recessions) and rise when incomes rise (during expansions). ▪ Taxes on corporate profits lower total tax bills when profits are lower (during contractions) and raise tax bills when profits are higher (typically during expansions). ▪ Unemployment compensation increases government spending automatically when the number of unemployed people rises and decreases government spending when fewer people are unemployed. ▪ Welfare programs also increase government spending during downturns and decrease government spending when the economy is doing better. ▪ Due to the existence of automatic stabilizers, it is expected that tax collections will fall and payments to the poor will rise. Thus automatic stabilizers cause budget deficits to increase during a recession. ▪ When real GDP decreases, automatic stabilizers increase tax revenue and decrease individual payments. • This is because when real GDP increases, people have more taxable income. In addition, government payments to individuals will decrease as fewer people are eligible for unemployment benefits or income aid to the poor. • Crowding-out: when private spending falls in response to increases in government spending o Complete crowding-out: every dollar of government spending crowds out a dollar of private spending ▪ If complete crowding-out occurs, the AD curve moves back to where it was pre-fiscal policy o When the government borrows, demands for loans increases o The new demand changes the equilibrium (increases equilibrium quantity) o Increased demand also increases interest rate o High interest rates discourage private investing • Savings shifts: New spending today has to be paid for someday, which means that taxes must rise sooner or later o New classical critique: increases in government spending and decreases in taxes are largely offset by increases in savings, because people know they’ll have to pay higher taxes eventually ▪ • Robert Barro, Robert Lucas, and Thomas Sergeant Summary of fiscal policy shortcomings: Supply-Side Fiscal Policy • Supply-side fiscal policy: using of government spending and taxes to affect the supply, or production, side of the economy • When LRAS shifts left, so does the level of full-employment output • LRAS is shifted by technology, resources, and institutions • Fiscal policies for supplies: (increases production incentives but takes time to impact aggregate supply) o Research and development tax credits: tax breaks are given to firms that discover new technology o Policies that focus on education: incentivizing education/ education and training increase effective labor resources and thus increase aggregate supply. o Lower corporate profit tax rates: Lower taxes increase the incentives for corporations to undertake activities that generate more profit. o Lower marginal income tax rates: incentivizes individuals to work harder and produce more Marginal Income Tax Rates • Lower > increases aggregate demand • Raising income tax rates can increase tax revenue. But it turns out that if you raise taxes too high, tax revenue declines because the high rates provide negative incentives for production • The Laffer Curve o ↑income tax revenue = ↑tax rate × income o In region I of the Laffer curve, where tax rates are relatively low, increases in tax rates lead to increases in tax revenue. o In region II, where tax rates are relatively high, increases in tax rates decrease tax revenue o T* is the rate that tax revenue is maximized (economists don’t agree) Bonus Notes: • chronological order the lag phenomena associated with the use of fiscal policy to smooth business cycles: o recognition lag o implementation lag o impact lag • Monetary policy and fiscal policy are two different tools used by the federal government to influence the economy. o Monetary policy concerns using the national money supply to affect the economy o fiscal policy uses taxes and expenditures in the government’s budget. • Chronology: o start of Great Recession o Economic Stimulus Act of 2008 o national elections o American Recovery and Reinvestment Act of 2009 o end of Great Recession • The Laffer curve models tax revenue as a function of a single tax rate. In a progressive scheme, one has to look separately at the revenue from different segments of taxpayers, corresponding to different rates. The data in the table suggests that tax cuts in the early 1980s led to less revenue from lower-income taxpayers but more revenue from the highest-income taxpayers. This would mean that reductions in the top marginal rate, at least, made fiscal sense. • Expansionary fiscal policy used during economic downturns inevitably leads to a budget deficit. Suppose the government responds to the downturn by increasing government spending by $250 billion, but keeps tax rates the same. In this scenario, the deficit will rise by more than $250 billion. In a recession, income falls and unemployment rises, which means tax revenues will fall even if tax rates do not change.