11/19/2019 13 FISCAL POLICY Government Spending and Tax Policy Part 1 In this chapter: Look at the federal budget history of outlays, receipts, deficits, and debt Explain the supply-side effects of fiscal policy - supply side economics Review how fiscal stimulus is used to fight a recession The Federal Budget Federal budget - statement of federal government’s outlays and tax revenues. Has two purposes: 1. Finance federal government programs and activities 2. Achieve macroeconomic objectives Fiscal policy - use of the federal budget to achieve macroeconomic objectives, such as full employment, economic growth, and price stability. 1
11/19/2019 Fiscal Policy Framework The Employment Act of 1946 . . . it is the continuing policy and responsibility of the Federal Government to use all practicable means . . . to coordinate and utilize all its plans, functions, and resources . . . to promote maximum employment, production, and purchasing power. The Federal Budget • Government Receipts come from: (1) personal income taxes, (2) Social Security taxes, (3) corporate income taxes, (4) indirect taxes. • Personal income taxes are the largest source of receipts. The Federal Budget • Government Outlays are: (1) transfer payments, (2) expenditure on goods and services, (3) interest of the debt. • Transfer payments are the largest item of outlays. • https://www.treasurydirect.gov/govt/reports/pd/ mspd/2019/opds102019.pdf 2
11/19/2019 The Federal Budget Surplus or Deficit • Budget balance equals receipts minus outlays (T – (G + Transfers)) or ((T – Transfers) - G) • If receipts (T) exceed outlays (G + Transfer), the government has a budget surplus . • If outlays exceed receipts, the government has a budget deficit . • If receipts equal outlays, the government has a balanced budget . • The budget deficit in fiscal 2017 was $665 billion and $779 billion in 2018. It was $1,300 billion in 2010. The Federal Budget Revenues and outlays as percent of GDP – nominal terms. The Federal Budget Government debt is the total amount that the government has borrowed. It is the sum of past deficits minus past surpluses. the federal government’s gross debt ... and net debt. https://www.treasurydirect.gov/govt/reports/ pd/mspd/2019/opds102019.pdf http://ticdata.treasury.gov/Publish/mfh.txt 3
11/19/2019 Debt and Capital • Businesses use debt to buy assets that yield a return (hopefully greater than interest cost). • The government uses debt to buy assets that yield a social return - hopefully greater than the interest cost. • But , a lot of government debt is incurred to finance consumption and transfer payments with little or no social return. • State government spending on highways, education, etc. yield a social return. Effects of Fiscal Policy • How do taxes on personal and corporate income affect real GDP? • Some economist argue the effect to be large. • In addition to effect on AD, they argue fiscal policy has important effects on employment, potential GDP, and aggregate supply -called supply-side effects . Effects of Fiscal Policy • We use tools developed in chapter 6 to determined how full employment quantity of labor and potential GDP are determined. • We first show the supply-side effect of the imposition of an income tax on the full employment quantity of labor and potential GDP change. • We then look at the possible supply-side effects of lowering taxes on the full employment quantity of labor and potential GDP. 4
11/19/2019 Supply-Side Effects of Fiscal Policy We start without taxes. Assume equilibrium employment is full employment at 250 million. LS is labor supply. LD is labor demand. - chapter 6 stuff. Supply-Side Effects of Fiscal Policy Do we tax income. The Effects of an income tax is to reduce the supply of labor. An income tax drives a wedge between the cost of labor to employers and employee take home pay. The supply of labor decreases because the tax decreases the after- tax wage rate reducing the incentive to work. Supply-Side Effects of Fiscal Policy The before-tax real wage rate rises, but the after-tax real wage rate falls. The quantity of labor employed decreases. The gap created between the before-tax and after-tax wage rates is called the tax wedge . Note: This example uses a high tax rate, $15 tax on a $35 wage rate - a 43% tax rate. A lower tax rate would have a smaller affect. 5
11/19/2019 Supply-Side Effects of Fiscal Policy When the quantity of labor employed decreases, … potential GDP decreases. The supply-side effect of the income tax is to decrease potential GDP and decrease aggregate supply. When economist estimate potential GDP they consider taxes currently in place. If the income tax rate is lowered, the effect is to increase the supply of labor and potential GDP. In Chapters 10,11 and 12 We Discussed the Demand Side Effects of Tax Policy. • Lower autonomous T => Yd = C = AD = Y and P • This is short-run policy aimed at increasing AD. • We talked about multipliers and that neat stuff. • Notice the next slide title refers to tax rates (t) Supply-Side Economics Proposes Lower Tax Rates • Supply-siders feel income taxes weaken the incentive to work. • They propose lowering personal income tax rates (t) to increase the incentive to work which increases the supply of labor and potential GDP. • Lowering income taxes reverse everything on the earlier slides. • This is a long-run fiscal policy aimed at shifting the LAS to the right. 6
11/19/2019 Supply-Side Economics Proposes Lower Tax Rates • Supply-siders also propose lower corporate income tax rates to increase incentive to invest. • Big question is how large is the effect on aggregate supply. • No consensus on how strong the supply-side effect is. Keynesians and Supply Siders Compared Keynesians argue lower taxes increase AD: Chapter 10, 11 and 12 analysis. P LAS 0 SAS 0 P 1 B P 0 A AD 1 AD 0 Y pot Y 1 Y In the SR: T => Y d =>C => AD => Y and P . Move from point A to B. 7
11/19/2019 Keynesians – Long Run SAS 1 P LAS 0 SAS 0 P 3 C B P 2 P 0 A AD 1 AD 0 Y Y pot In LR: Y returns to Y pot and the multiplier = 0. But, both the deficit and debt increase because the government borrows to finance the tax cut. Supply Siders say lower tax rates (t) shift AD right AND also shift LAS and SAS to the right SAS 1 SAS 2 P LAS 0 LAS 1 SAS 0 C P 3 P 4 D B P 2 P 0 A AD 1 AD 0 Y pot Y Y pot1 In LR, Y pot increases to Y pot1 . P does not rise as much (P 4 compared to P 3 ) and the multiplier in the long-run > 0, Ypot / T >0. Also, tax revenues increase as Y increases: T = (t x Y) as potential GDP increases. The deficit does not increase as much. Big Question – How large is the supply- side effect on AS? P LAS 0 LAS 1 SAS 0 P 2 C P 3 B P 0 A AD 1 AD 0 Y pot Y pot1 Y If small, closer to point C in the long-run – the Keynesian result. If large, closer to point B. 8
11/19/2019 Supply-Side Effects of Fiscal Policy Taxes and the Incentive to Save and Invest • Interest income is currently taxed • Actually, all investment/capital income is taxed • Interest income • Dividend income • Capital Gains Supply-Side Effects of Fiscal Policy Taxes and the Incentive to Save and Invest • Premise: A tax on interest income lowers the quantity of saving and investment and slows the growth rate of real GDP. • The interest rate that influences saving and investment is the real after-tax interest rate. • To calculate the real after-tax interest rate, we subtract the income tax paid on nominal interest income. Supply-Side Effects of Fiscal Policy Taxes and the Incentive to Save and Invest • If nominal interest rate is 5% and tax rate (t) is 25%, the after tax nominal interest rate is: 5% - (.25 x 5%) = 3.75% • Adjust for inflation: If inflation is 2%, subtract inflation to get the real after-tax interest rate: 3.75% - 2.00% = 1.75% 9
11/19/2019 Supply-Side Effects of Fiscal Policy Income tax on interest and capital income reduces the supply of loanable funds and raises interest rates and discourages investment. Have a tax wedge driven between the real interest rate and the real after-tax interest rate. Saving and investment fall from $2 trillion to $1.8 trillion. Lower investment means lower capital stock which means lower potential GDP. Supply-Side Economics In addition to lowering income taxes, supply-siders propose lowering personal and corporate taxes on interest and capital income in order to increase saving and investment. • Supply of loanable funds shifts to the right, interest rates are lower and investment increases. • Capital stock increases and potential GDP increases. • LAS shifts to the right. Impact on Loanable Funds real interest SLF rate SLF lower tax rate A 4% B 3% DLF $1.8 loanable funds (Trillions$) $2.0 SLF increases, the real interest rate decreases and investment increases 10
11/19/2019 Impact on Potential GDP P LAS 0 LAS 1 SAS 0 A SAS 1 P 0 B P 1 AD 0 Y Y pot Increased Investment => capital stock increases and potential GDP increases. LAS shifts to the right. 11
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