Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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N. Gregory Mankiw, Principles of Economics, 8th Edition

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Case, Fair, Oster, Principles of Economics, 12th Edition

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McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

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Chapter 26: Fiscal Policy

Figure 26.1: Ronald Reagan signs the Economic Recovery Tax Act reducing income tax rates. The tax cuts came to be known as the core of “Reaganomics.”[1]

​“Americans are the most generous, kindhearted people on earth as long as they’re convinced not one dollar of it is going for taxes.” Will Rogers

“The fact that we are here today to debate raising America's debt limit is a sign of leadership failure... It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government's reckless fiscal policies.” Barack Obama

“The great thing about fiscal policy is that it has a direct impact and doesn't require you to bind the hands of future policymakers.” Paul Krugman

26.1​ Objectives

After reading this chapter, you should be able to:

  • ​Understand the effects of changing taxes and spending on employment and inflation.
  • Understand the challenges and controversies confronted in using fiscal policy.
  • Understand the costs and benefits of federal budget deficits, surpluses, and debt.
  • Make recommendations as to appropriate fiscal and monetary policies under a variety of economic circumstances.
ECN26_figure26.2_updated.jpg
Figure 26.2: Tax Cuts and Fiscal Policy.

Why did the tax and spending changes listed in Figure 26.2 happen? After all, wouldn’t we expect national leaders to arrive at an economically viable tax structure and stick with it? The quotes at the beginning of this chapter illustrate the fact that fiscal policy is one of the most contentious issues facing governments in advanced economies. In this chapter, we will explore the economics and politics of these contentious and constantly-changing fiscal policies.

26.2​ Fiscal Policy Tools

Fiscal policy Government spending is financed through taxes and borrowing. If government spending exceeds tax revenue, the government is running a deficit and must borrow to cover the shortfall. If tax revenue exceeds spending, the government is running a surplus.

With the exception of a few years during the Clinton Administration in the late 1990s, the United States Federal Government has run a deficit in every year since 1975. This is unsurprising because research shows that the state of the economy is one of the most important factors in determining who wins presidential elections. Some researchers have even found a business cycle in which the economy slows after a presidential election and speeds up beginning a year before the next election, a fact suggesting that many changes in fiscal policy happen because of political rather than economic motivations.

Federal government spending is often criticized for wastefulness and for simply being too large. Yet even when the economy is booming, government spending provides many services that probably would not exist in the absence of these government programs. Consider, for example, the Social Security program that provides retirement income for millions of Americans and coincides with the reduction of poverty among the elderly by two-thirds, or the Head Start program that provides food, healthcare, and education to children from poor families.1 As another example, the internet, which pervades modern life, was originally created and funded by the U.S. military. Many other inventions and technological improvements have come from research funded by the National Science Foundation. From the Center for Disease Control and Prevention to our national parks and military, the vast majority of economists agree that some government spending can provide socially valuable goods and services.

At the same time, the taxes that fund these programs reduce your and your families’ disposable incomes. You take fewer vacations, buy smaller homes, spend less on education, and save less because of those higher taxes.

Every day the debate continues about how much to spend, what government programs to emphasize, and whether taxes should be raised or lowered. There are few discussions in Washington that are more serious and carried on at the fever pitch that is applied to discussions about taxation and government spending. These decisions affect millions of businesses and all of us as taxpayers. But from a macroeconomic perspective, they can also affect overall economic growth, prices, and unemployment.

Often, the term “fiscal policy” is used to mean deliberate actions by the federal government to change taxes and to spend with a goal of influencing economic conditions. But we will also look at the economic effects of tax and spending changes that are originally contemplated for totally separate reasons.

Fiscal policy applies at all levels of government, including federal, state, and local government budgets. Important budgetary decisions include spending on goods and services and transfer payments such as Social Security, the earned income tax credit, Supplemental Nutrition Assistance, Medicare, and unemployment compensation. Revenues are almost all taxes on individuals and businesses. The largest portion of federal revenues is from income taxes on individuals.

Here is a video explaining the earned income tax credit:

Using our planned spending model and our aggregate supply and demand model, let’s first calculate the effects of an increase in spending on goods and services, then changes in taxes, and then changes in transfer payments.

26.2.1​ Changes in Spending

​You have the tools to analyze how various changes in fiscal policy will affect the economy. We will now apply the model developed in previous chapters to understand how these various types of fiscal policy affect the economy. If government increases spending on goods and services, for example, greater funding for military or national parks, what will be the effect on the overall economy? In the GDP accounts, government spending increases. That causes total spending to rise as government pays for, for example, salaries of national park employees or metals used to make military equipment. The incomes of park employees and metals manufacturers rise, and these individuals in turn spend some of their increased income on goods and services, that is, their consumption spending rises. The result is that total spending rises by more than the initial increase in government spending. The total effect is the initial increase in spending times this spending multiplier.

Aggregate demand increases by the multiplied amount of spending. That puts upward pressure on prices and output begins to increase. In the short run, real economic activity (GDP) rises. This greater production is accomplished in part when firms hire more labor and unemployment falls as employment increases. Prices tend to rise, meaning inflation increases. How much output increases and how high prices go depends upon the slope of the aggregate supply curve.

Graphing Question 26.01


Question 26.01

What happens to real GDP, employment, and prices if government spending increases? Assume we start in a long-run equilibrium for the economy and go to a new short-run equilibrium.

A

Real GDP rises, employment falls, and prices rise

B

Real GDP rises, employment rises, and prices rise

C

Real GDP rises, employment rises, and prices fall

D

Real GDP falls, employment falls, and prices fall

26.2.2​ Changes in Taxes

​Tax changes also affect demand, prices, and output. If, for example, income taxes increase, disposable income decreases. Consumers begin to decrease consumption spending. That decrease in consumption spending has a further effect on total spending. The ultimate effect is a larger decrease than the initial decrease due to the additional decrease in consumption spending via the multiplier. The total effect is the initial decrease in consumption spending times the spending multiplier.

Aggregate demand decreases by the multiplied amount of spending. That puts downward pressure on prices and output begins to decrease. We end up with smaller real GDP, lower employment (greater unemployment), and lower prices.

Question 26.02

What happens to real GDP, employment, and prices if income taxes increase? Assume we start in a long-run equilibrium and go to a new short-run equilibrium. Choose one of the following:

A

Real GDP rises, employment rises, and prices rise

B

Real GDP rises, employment rises, and prices remain constant

C

Real GDP falls, employment falls, and prices rise

D

Real GDP falls, employment falls, and prices fall

26.2.3​ Changes in Transfer Payments

The effects of a change in transfer payments are analyzed by considering the effects on income. An increase in transfer payments increases consumers’ incomes. GDP increases via the multiplier. The total effect is the initial increase in consumption spending times the multiplier. Aggregate demand increases by the multiplied amount of spending. That puts upward pressure on prices and output begins to rise. We end up with greater real GDP, higher employment (lower unemployment), and higher prices.

Question 26.03

What happens to real GDP, employment, and prices if transfer payments decrease? Assume we start in a long-run equilibrium and go to a new short-run equilibrium. Choose one of the following.

A

Real GDP falls, employment falls, and prices fall

B

Real GDP falls, employment falls, and prices rise

C

Real GDP rises, employment rises, and prices rise

D

Real GDP rises, employment falls, and prices rise

Figure 26.3: Fiscal policy.​

26.2.4 Recessions

Question 26.04

Use our models to recommend policy if we are facing a recession.

A

Raise government spending, raise taxes, increase transfer payments

B

Lower government spending, lower taxes, decrease transfer payments

C

Raise government spending, lower taxes, decrease transfer payments

D

Raise government spending, lower taxes, increase transfer payments

26.2.5​ Temporary Tax Changes

​In the list of tax cuts in Figure 26.2, three were implemented as temporary changes. In 1968, Lyndon Johnson temporarily raised taxes to help reduce inflationary pressures that were largely due to increases in government spending, but this was during a time when the economy was already producing at the full-employment level of real GDP. Gerald Ford gave a temporary income tax rebate to stimulate the economy out of a recession. George Bush increased individuals’ disposable income by temporarily lowering the amount withheld from paychecks for income taxes.

None of these efforts was nearly as successful as intended.

Question 26.05

Why were the temporary tax changes, discussed above in section 26.2.5, not successful?

A

Temporary tax changes were too small

B

Temporary tax changes do not affect income

C

Temporary tax changes affect only current but not future income

D

Temporary tax changes affect future but not current income

​26.2.6 Supply Shocks

​In our discussion of monetary policy, we discussed policy in recessions, inflationary periods, and supply shocks. The appropriate monetary policy was more obvious in recessions and inflationary periods and less obvious in negative supply shocks. There are two choices for policy in a supply shock: (1) increase spending, thus decreasing unemployment and increasing inflation further, or (2) decrease spending, thus reducing inflation and increasing unemployment further. Either way, we make one problem worse in our attempt to make one problem better. Expansionary fiscal policy also cannot solve the problem, since an increase in aggregate demand causes both inflation and increased output. So what do we do? The decision depends upon our interpretation of the seriousness of each problem and boils down largely to a value judgment.

Typically, labor unions, liberals, and Democrats tend to support policies that support economically-vulnerable populations. They thus tend to support policies that reduce unemployment during recessions. In the context of fiscal policy, this would mean increasing government spending and lowering taxes, especially during recessions. Conservatives, Republicans, and lenders tend to support policies that promote long-run fiscal sustainability, and to favor reducing inflation. In the context of fiscal policy, this typically entails preferring less government spending and budget surpluses, even during recessions.

Presented with these policy preferences, it may appear that there is no way to increase employment without causing an increase in inflation during recessions. But there is another way: if policy can increase aggregate supply, both unemployment and inflation will fall. And because output also rises, so will tax revenue, thus reducing government deficits. These effects are all beneficial, so policies that increase aggregate supply support a strong economy in both recessions and booms.

26.2.7​ Reaganomics

Supply-side economics is the idea that taxes can increase aggregate supply by creating increased incentives to work, save, and invest.

On August 13, 1981, on a round, wood picnic table in front of his ranch house high above Santa Barbara, President Ronald Reagan signed the Economic Recovery Tax Act. The bill reduced income tax rates in three annual stages: first by 10 percent, second by another 10 percent, and finally by 5 percent. The tax cuts came to be known as the core of “Reaganomics.” The reasoning was that if taxes were lower, people would return to working hard and investing, and that this would make the economy grow more rapidly. In a grand experiment, supply-side tax cuts were used more aggressively than had been done before. It was also hoped that the tax cut would encourage so much additional employment and investment that the economy would grow rapidly, and the tax cut would actually increase overall tax receipts, with lower rates applied to a larger economic pie.

The experiment was never really allowed to come to fruition as the Federal Reserve slowed the growth of the money supply to counter the future effects of the lower taxes on the already unacceptably high rate of inflation (measured by the annual growth in the CPI, inflation reached an annual rate of 14.6 percent per year in the spring of 1980). In the end, the tax cuts came at a time when the Fed pursued contractionary monetary policy. It is thus not surprising to see little effect of tax cuts on total spending.

There is little doubt that lower taxes do have supply-side effects – individuals respond to incentives. The debate among economists and politicians is over how much they respond, and we really do not know that with much precision. So the debate is over the size, not the direction, of the effect of supply-side policies like Reaganomics.

The consensus over the effects of that type of tax cut is shown in Figure 26.4. A tax cut should increase investment. The effects of the increased investment will be to increase total spending and eventually to increase aggregate supply. The major initial effect of the tax cut is on spending. Some of the effects are on supply and full-employment GDP as shown by the new dashed lines. However, the net effect can be too much spending, which creates inflationary pressure. The spending increase takes us from point A to point B. The subsequent smaller effect on supply takes us from point B to point C. We get less inflation than if spending increased alone, but the policy is still an inflationary one.

Figure 26.4: Supply Side Effects.

​Supply-side economics is not just about lowering taxes on individuals. Traditionally, a capital gains tax affects aggregate supply. The theory is that if corporate costs of investing are lowered through increased tax credits or reductions in corporate tax rates, corporations will undertake increased investment and the economy will grow faster in the long run. The traditional supply-side tax cuts, like those used in the Kennedy-Johnson tax cut of the 1960s, were to lower taxes on businesses to stimulate investment directly.

Supply-side economics continues to be discussed in presidential campaigns and in Congress. Much of the debate is centered upon proposals to:

  •  Reduce corporate income tax and capital gains taxes
  •  Reduce taxes on dividends and interest
  •  Lower personal income taxes
  •  Make regulation more clear and predictable

​The modern supply-side tax cuts discussed in Congress today tend to focus on capital gains tax cuts and individual income tax cuts rather than on regulations. Nevertheless, reducing taxes on income from saving is intended to increase rewards to saving. (Earlier we talked about how this effect was a very small one, if it exists at all.) If individuals increase their saving, investment will increase in the long run. Increased investment will expand capacity and expand supply.

There is considerable controversy, but the economic consensus is that tax cuts on businesses seem to be more effective in stimulating supply than tax cuts on individuals. The ability and willingness of individuals to work harder seem to be limited.

Many business leaders say that they invest less because of the high cost of complying with business regulations, along with a lack of clarity with respect to regulations. Clearer and predictable regulation can act as a supply-side measure if it encourages businesses to take risks and invest in new projects.

Figure 26.5: Major Tax Changes

For each tax cut below, indicate whether it would primarily affect aggregate demand, aggregate supply, or both.

Question 26.06

Per-Child Tax Credit

A

Aggregate demand

B

Aggregate supply

C

Aggregate demand and Aggregate supply

Question 26.07

Education Tax Incentives

A

Aggregate demand

B

Aggregate supply

C

Aggregate demand and Aggregate supply

Question 26.08

Capital Gains Tax Cuts

A

Aggregate demand

B

Aggregate supply

C

Aggregate demand and Aggregate supply

Question 26.09

Estate Tax Cuts

A

Aggregate demand

B

Aggregate supply

C

Aggregate demand and Aggregate supply


Graphing Question 26.02

26.3​ The George H.W. Bush Tax Changes

​The 2001 tax cut was enacted to counteract a mild recession. This tax cut lowered tax rates and expanded several different tax benefits over a 10-year period. The tax cuts of 2003 accelerated a number of provisions in the 2001 tax cut and cut taxes on capital gains and dividends. For the tax year 2003, the 2001 act created the 10 percent tax bracket, reduced most tax rates by a percentage point or so, increased the child tax credit to $600 per child, and made a number of other changes.

The 2003 tax cut accelerated the major provisions of the 2001 tax cut, such as individual tax rate reductions, marriage penalty relief, and the $1,000 per child tax credit. It also reduced taxes on capital gains and stock dividends.

Table 26.1: The George H.W. Bush Tax Changes​​

Question 26.10

Question 26.10

For each of the following policies, indicate the effects on spending in the economy: 2001 tax changes, 2002 deduction for investment spending, 2003 income tax change, 2003 reduction in capital gains taxes

Hover here to see the hint for Question 26.10.
Click here to see the answer to Question 26.10.

Indicate whether each of the changes below is demand- or supply-side, or both.

Question 26.11

2001 change to income tax:

A

Demand side

B

Supply side

C

Demand and Supply Side

Question 26.12

2002 tax change to investment:

A

Demand side

B

Supply side

C

Demand and Supply Side

Question 26.13

2003 tax change:

A

Demand side

B

Supply side

C

Demand and Supply Side

​26.4 Fiscal Policy in 2009

The 2007-2009 recession in the U.S. was one of the worst since the Great Depression. The unemployment rate hit 10 percent in October of 2009, with firms laying off millions of workers. The effects were felt throughout the economy as consumers and businesses pulled back on spending, thereby reducing other individuals’ incomes.

The American Recovery and Reinvestment Act of 2009 (passed in February of 2009) was designed to increase government spending with the goal of covering the shortfall in private spending. The entire bill is estimated to cost $749 billion dollars, an amount equal to more than 5 percent of GDP at the time or about $2,500 per U.S. citizen, measured in 2009 dollars. However, the spending occurred over the course of several years. According to a 2012 Congressional budget office report, only $494 billion was spent between 2009 and 2011, with the remainder to be spent by 2019.

Table 26.2: American Recovery and Reinvestment Act of 2009​

​The spending on goods and services was done by the federal government as well as state and local governments. It included a wide variety of activities, including health care technology, expansion of broadband, highway construction, and education. Part of the payments to state governments was to encourage spending on goods and services, but also to provide funds so that state and local governments did not need to reduce spending in response to falling tax receipts.

Individual taxpayers received tax reductions of approximately 31 percent of the total. Those tax cuts included $400 tax credits over two years, first-time home buyer credits, and increases in child and college tuition tax credits. Businesses received tax cuts of a much smaller amount.

Some of the spending was transfer payments to individuals – primarily extending unemployment compensation to unemployed individuals, but also one-time $250 payments to retirees.

Did the stimulus work? James Feyrer and Bruce Sacerdote of the National Bureau for Economic Research showed that each $100,000 of non-education stimulus spending created about one additional job, implying a fiscal multiplier of about 2.0, i.e., an increase in GDP of $200,000. At the same time, this figure was near the top of their estimates, and they report much lower multipliers for other types of spending and using different approaches. Economist Robert Hall argues that fiscal multipliers are around 1.7 when short-run nominal interest rates are near zero, as they were in the aftermath of the 2007-2009 recession. The reason we might expect expansionary policy to have a bigger effect when short-run interest rates are zero is because in such a situation, the expansionary fiscal policy does not cause interest rates to rise, which would lead to a reduction in investment spending.

Graphing Question 26.03

26.5​ Problems with Implementing Fiscal Policy

​“The attachment of voters to public services for which they are unwilling to tax themselves has more or less paralyzed fiscal policy and made it vulnerable to the lowest-common-denominator politics.” - Robert Solow, an economist at MIT

We have seen that increases in government spending, increases in transfer payments, and decreases in taxes all stimulate economic activity, while decreases in spending, reduced transfer payments, or increases in taxes slow economic activity. There are thus multiple instruments that policymakers can use to stimulate economic activity. What is the right policy mix, and what types of policies are actually implemented? The answer is both economic and political.

26.5.1​ Crowding Out Private Investment

​First, one challenge is that stimulative fiscal policy can crowd out private sector investment.

Consider the following chain of events. Federal spending increases. The increase in spending causes a multiplied increase in total spending. That, in turn, causes an increase in the demand for money. Interest rates rise. But higher interest rates raise borrowing costs, and so investment spending falls. But we also know that as total spending rises and real GDP increases, investment spending will increase. So what does happen to investment spending?

If we are near full employment or producing more than the full-employment output, the increased spending will not cause a great deal more real GDP as there are likely to be small positive effects on investment. Interest rates will rise, lowering investment. On net, output might fall.

If we are in a recession, the increase in spending will have a much larger effect on real GDP. In that case, the positive effect on investment may be much larger and the net effect is likely to be positive.

Figure 26.6: The effect of an increase in government spending on total spending.​​

​If the increased interest rate effect is larger than the direct increased investment spending, then overall investment declines. Economists say that investment then is “crowded out.” If the total spending creating a need for increased capacity is greater than the interest rate effect, then there will be more investment, and economists use the very awkward term of “crowding in.” (Remember, they are not poets!)

Another way to understand the phenomenon is to think about the demand for loans. As government increases its borrowing resulting from the increased deficits, banks are able to increase their interest rates. Some businesses then begin to cut back on investment. With an economy that has more slack in it, banks may not be fully loaned out and interest rates may not increase as much.

The above discussion illustrates how changes in interest rates, which can crowd out investment, can affect output: Since investment is a component of demand, lower investment spending can mean lower aggregate demand and thus lower output growth, over the short run.

26.5.2​ Political Considerations

A second challenge is that fiscal policy is implemented with lags, especially for government spending: Tax changes can be implemented quickly, while changes in government spending take a long time. There are two reasons for this. First, spending must be agreed upon prior to a congressional vote. For example, will government spending dollars go primarily to rural or urban areas? Different congressional representatives have different constituents across the country, and so debates about spending can take time. Second, even after Congress passes spending plans, their implementation can take months or even years, as was seen from the example of the 2009 ARRA stimulus.

Figure 26.7: Biases in Fiscal Policy​

​An additional factor to keep in mind is that it can be politically difficult to raise taxes when the economy is in an inflationary state. Imagine a President addressing the American people by saying: “I am here to help you. I know you are suffering from higher prices and lower real incomes. I will propose tomorrow that Congress raise taxes by ten percent.” Lowering spending may be politically more successful. But even that may be difficult. Any time spending is lowered, some group of individuals or businesses is hurt and will object.

In a recession, lowering taxes and raising spending may be easier to accomplish. Given the political ease, it may be politically easier to stimulate the economy than to slow it down. Thus there may be a bias toward creating inflationary conditions.

In either set of economic conditions, the choice between changing taxes and changing spending may be a value judgement. A political conservative may be much more likely to favor lowering taxes than raising spending to stimulate the economy and favor lowering spending over raising taxes to slow the economy down. A liberal who values larger government programs may be much more willing to use increases in spending to stimulate the economy and increases in taxes to slow the economy down.

       Economists offer new arguments for U.S. research tax break [1]

​"The National Association of Manufacturers (NAM), one of the nation’s largest industrial trade groups, today released a report from three academic economists that reviews the scholarly literature on the economic impact of the so-called R&D tax credit, worth some $7 billion annually in recent years. It concludes that making the credit permanent—a long-sought goal of industry and science groups—could boost the U.S. gross domestic product (GDP) by 0.16% annually and add between 36,000 and 38,300 jobs each year." 

                  -David Malakoff for Science Magazine, January 15, 2015

26.6​ Automatic Stabilizers

​“Tax receipts collapse as economy continues to slow”

Figure 26.8: Direction of Causation Makes a Difference​

We found earlier in this chapter that an increase in income tax rates would decrease disposable income and eventually decrease total spending in the economy. Yet as the economy grows, tax receipts increase. This is because most taxes, such as income taxes, are levied as a proportion of total income.

Why is there a seeming difference between the quote above and our finding that increases in tax rates can decrease disposable income, eventually decreasing overall economic activity through the multiplier? The direction of causation is crucial in understanding the explanation. If income tax rates increase, disposable income falls, consumption falls, and spending shrinks, then tax rates are changing first.

If the spending in the economy is growing for some reason other than changes in tax rates, then with a fixed income tax rate, tax receipts will actually increase. Twenty-five percent of a large economy is a larger number than twenty-five percent of a smaller economy. In this case, it is spending that is rising first.

​Our tax system and, to a lesser extent, our government spending on transfer payments act as automatic stabilizers. An increase in spending will not have the full-multiplied effect that it otherwise would because some of the effects are diverted into income taxes and not spent. Thus the multiplier is smaller because of income taxes. And as spending rises and more people go to work, transfer payments for unemployment compensation and welfare begin to fall. This also offsets some of the multiplied effects of the initial change in spending.

The reverse is also true.

Graphing Question 26.04


​We can conclude that our economy is more stable as a result of our systems of taxes based on a percentage of income and transfer payments made to those without jobs or in need – and it happens automatically. Therefore, we use the term automatic stabilizers.

26.7​ Budget Deficits and Debt

"The United States is Bankrupt!
The United States Federal Government Debt
Every American Owes $35,000"
   - An advertisement in the 2008 U.S. Presidential campaign

​By 2018, the year before the U.S. presidential election, gross national debt had grown to $66,978 dollars per citizen.

​In the minds of many Americans, the federal debt is one of the most serious economic and political problems. And indeed both were getting very large. The deficits (and subsequent surpluses) are shown in Figure 26.8 and the total debt is shown in Figure 26.10. Taxes were increased in 1990 and 1993, pressure was brought to bear by Congress and the administration to hold down spending, and the economy has grown rapidly in the last of the 1990s. Each of these has meant that the deficit was shrinking and has placed the economy in a position where we reached a budget surplus in 1998.

That surplus continued for four years, at which time a combination of lower taxes and higher spending contributed to record absolute deficits that were significant on a relative basis (as a percentage of GDP).

ECN26_figure26.9_updated.jpg
Figure 26.9: Federal debt held by the public as a percent of GDP is shown by year.

​Figure 26.10 shows the current sources of federal government revenue and categories of spending. Eighty percent of tax receipts come directly from individuals. Therefore, almost any attempt to reduce deficits through tax changes is going to affect individuals directly.

The categories of spending show how difficult it is to cut government budgets. The vast majority of the spending is on categories such as interest payments that simply cannot be cut or items such as Social Security and Medicare, where there are large groups providing political support.

ECN26_Figure26.10_updated.jpg
Figure 26.10: 2018 Fiscal Budget (Estimated).

From time to time, members of Congress have proposed constitutional amendments requiring the federal budget to be balanced at all times.​

Question 26.14

Question 26.14

Assuming such an amendment or law were passed, analyze the consequences during a recession.

Hover here to see the hint for Question 26.14.
Click here to see the answer to Question 26.14.

        ​Greenspan Sounds Alarm on Threat From the Deficit [2]

​"Completing two days of testimony to Congress on monetary policy, Mr. Greenspan defended the $1.3 trillion in tax cuts that Congress enacted in 2001, saying the cuts helped stave off a deeper recession than the one the economy suffered that year. [...] 

"The Fed chief urged Congress to adopt rules that would require spending increases to be offset by tax increases, or tax cuts to be offset by spending cuts. "Overall, I would say that looking forward, fiscal policy has become a critical issue on the agenda for macroeconomic policy," he said."

                   -Greg Ip for The Wall Street Journal, July 21, 2004    

Question 26.15

Why would Alan Greenspan care about fiscal policy?

A

The Fed Chair controls tax policy

B

The Fed Chair is responsible for the government deficit

C

Monetary and Fiscal Policy interact

26.7.1​ What Is Wrong with Deficits and Debt? Myths and Reality

26.7.1.A Deficits Cause Inflation

Indeed they can. If we are at full employment and taxes are lowered or government spending increased, total spending will rise and we will cause inflation. In the short run, output will also increase, but eventually the economy will return to the full-employment level of real GDP with higher rates of inflation. But if we are in a recession, then decreased taxes and increased spending will cause the economy to return to full employment with little inflation. So whether or not deficits cause inflation depends upon current economic conditions. There are improper times and better times to deliberately increase the deficit or decrease the surplus.

26.7.1.B​ Bankruptcy

Large and growing deficits will add the debt. The argument goes that we will never be able to pay the debt back. If indeed we could not pay it back or could not make the interest payments on the debt, then the U.S. government would be in bankruptcy. Corporations go into bankruptcy when their debt grows so large that they can no longer meet their obligations. Given that individuals and financial institutions are willing to lend the federal government money at lower interest rates than any corporation, they are apparently confident of being repaid.

26.7.1.C Passing Debt onto Children​

We do pass debt onto children. But we also pass on assets along with our debt. We borrow primarily from ourselves. Future generations are responsible for making interest payments. But those future generations also own the bonds representing the assets through pension funds, insurance policies, and financial investments. They will also benefit from the roads, bridges, buildings, and increased productivity the borrowing helped finance. To the extent that bonds are owned by individuals and institutions abroad, there will be future obligations to make interest payments to people outside of our borders.

26.7.1.D​ Individuals Cannot Run Continual Deficits

Individuals are different from governments. Governments live on and have the ability to tax workers and corporations in the economy. But individuals do borrow, and some even increase their borrowing over their lifetimes. It is not uncommon for adults to take out larger and larger mortgages on more expensive homes as they are financially more successful.

26.7.1.E​ Real Costs of Debts

Increased government debt can prevent future fiscal policy. Specifically, as debt increases, so does the cost of making interest payments. To pay this cost, the government must raise taxes or decrease spending, thus leaving fewer funds for expansionary fiscal policy.

26.8​ How Should We Define Debt and Deficits?

26.8.1​ Inflation Accounting

Many would argue that the definitions are wrong. It is not the total amount of debt that counts, but the real value of the debt.

26.8.2 Debt as a Percentage of Income

Others would argue that we should look at debt as a percentage of GDP. If the percentage is increasing, then perhaps we should be concerned. If it is falling, even if the absolute amount is rising, the debt is less important. Indeed, Bill Gates can borrow far more than you and I, and easily pay the interest and the amount of the loan back. In the interactive graph below, the line showing debt as a percentage of GDP gives a quite different impression than does the line showing the absolute amounts of debt.


26.8.3 Debt for Investment Purposes

It matters what the government is borrowing for. If the government is simply borrowing to finance consumption-type purchases, then future generations will not be better off as a result. However, if the government is borrowing to finance education, highways, research and development, then future generations may well be better off.

​26.8.4 A Simplified Model

​To help us understand the effects of budget deficits, we will create a simple algebraic model of the circular flow diagram. Assume that the economy is in a long-run equilibrium, that is, at full employment output. Also assume for the time being, that there is no government spending or taxes and that there is no international trade.

Then we know that GDP = C + I, and that total income = C + S, C is consumption, I is investment, and S is saving.

Since in equilibrium, GDP will equal total income:

            ​ C + I = C + S, and therefore I = S.

​The meaning of the result is that if we reduce consumption and the economy returns to full employment eventually, there will be more resources left over for investment. Therefore, the economy will be able to grow faster.

Now for a more elaborate model. Let’s remove the assumption about no government. Now we will include government spending and taxes. Thus, GDP = C + I + G and total income = C + S + T, where G is government spending and T is taxes.

Since GDP = total income,

              ​ C + I + G = C + S + T

With a little algebra,

            ​ I + G = S + T or I = S + (T – G)

​This is really the same conclusion as above where investment was equal to saving. (T – G) is public saving. If there is a government surplus, that is if (T – G) is positive, there is public saving and there will be more resources left over for investment and higher growth later. If (T – G) is negative, we have a budget deficit and some of the resources that could have been used for investment are used to finance government spending and consumption. Investment will be less, and economic growth in the future will be lower than growth otherwise would have been.

A more sophisticated model will include net exports. We will do that in the next chapter. The interactive graph below shows that as the federal budget deficit rose in the 1980s and 90s, investment did fall.


Figure 26.11:​ "The extended baseline generally reflects current law, following CBO’s 10-year baseline budget projections through 2027 and then extending most of the concepts underlying those baseline projections for the rest of the long-term projection period [2047]. A [Other Revenues]: Consists of excise taxes, remittances to the Treasury from the Federal Reserve System, customs duties, estate and gift taxes, and miscellaneous fees and fines. B [Other Noninterest Spending]: Consists of all federal spending other than that for Social Security, the major health care programs, and net interest. C [Major Health Care Programs]: Consists of spending for Medicare (net of premiums and other offsetting receipts), Medicaid, and the Children’s Health Insurance Program, as well as outlays to subsidize health insurance purchased through the marketplaces established under the Affordable Care Act and related spending." [2].

The 2017 Long-Term Budget Outlook [4]

Summary

"At 77 percent of gross domestic product (GDP), federal debt held by the public is now at its highest level since shortly after World War II. If current laws generally remained unchanged, the Congressional Budget Office projects, growing budget deficits would boost that debt sharply over the next 30 years; it would reach 150 percent of GDP in 2047. The prospect of such large and growing debt poses substantial risks for the nation and presents policymakers with significant challenges."

Why Are Projected Deficits Rising? 

"In CBO’s projections, deficits rise over the next three decades—from 2.9 percent of GDP in 2017 to 9.8 percent in 2047—because spending growth is projected to outpace growth in revenues (Figure 26.14). In particular, spending as a share of GDP increases for Social Security, the major health care programs (primarily Medicare), and interest on the government’s debt."

"Much of the spending growth for Social Security and Medicare results from the aging of the population: As members of the baby-boom generation age and as life expectancy continues to increase, the percentage of the population age 65 or older will grow sharply, boosting the number of beneficiaries of those programs. "

"In addition, growth in spending on Medicare and the other major health care programs is driven by rising health care costs per person, which are projected to increase more quickly than GDP per capita (after the effects of aging and other demographic changes are removed). CBO projects that those health care costs will rise—although more slowly than they have in the past— in part because of the effects of new medical technologies and rising personal income. "

"The federal government’s net interest costs are projected to rise sharply as a percentage of GDP for two main reasons. The first and more important is that interest rates are expected to rise from their current low levels, making any given amount of debt more costly to finance. The second reason is the projected increase in deficits: The larger they are, the more the government will need to borrow."

"Mandatory spending other than that for Social Security and the major health care programs—such as spending for federal employees’ pensions and for various income security programs—is projected to decline as a percentage of GDP, as is discretionary spending. (Mandatory spending is generally governed by provisions of permanent law, whereas discretionary spending is controlled by annual appropriation acts.) The projected decline in discretionary spending stems largely from the caps on discretionary funding that are set in law for the next several years. "

"The modest projected growth in revenues relative to GDP over the next three decades is attributable to increases in individual income tax receipts. Those receipts are projected to grow mainly because CBO anticipates that income will rise more quickly than the price indexes that are used to adjust tax brackets. As a result, more income will be pushed into higher tax brackets over time. Combined receipts from all other sources are projected to decline as a percentage of GDP. "

What Might the Consequences Be If Current Laws Remained Unchanged? 

"Large and growing federal debt over the coming decades would hurt the economy and constrain future budget policy. The amount of debt that is projected under the extended baseline would reduce national saving and income in the long term; increase the government’s interest costs, putting more pressure on the rest of the budget; limit lawmakers’ ability to respond to unforeseen events; and increase the likelihood of a fiscal crisis, an occurrence in which investors become unwilling to finance a government’s borrowing unless they are compensated with very high interest rates."

                                -CBO, March 2017

                              Read the full report here

26.9​ Summary of Monetary and Fiscal Policy Effectiveness

Policy is slow to work. Part of the challenge in managing fiscal policy and monetary policy is that we must forecast future conditions. There are considerable lags between the time events happen in the economy and the time our policies begin to change conditions. The data lag (shown in Table 26.3) is a lag between the time the event happens and the time we recognize it. Preliminary real GDP estimates come out one month after the end of a quarter, unemployment figures are produced one week after the end of the month, and inflation figures appear two weeks after the end of the month. However, we do not normally base decisions on just one piece of evidence. We wait to see if a trend is developing – so the recognition lag is the time we wait for a new set of data to be generated.

Figure 26.12: Policy Lags​

​The legislative lag is the time it takes Congress and the President to get the legislation completed in the case of fiscal policy and the time for the Federal Reserve to act in the case of monetary policy. That legislative lag can be quite long for fiscal policy and is very short for the Federal Reserve. The transmission lag is how long it takes between the time we have decided to do something and when we actually do it. The transmission lag is tomorrow for the Federal Reserve. It is weeks for tax changes and months for spending changes. Finally, there is a time period before policy changes begin to have their full effects. That length of time for both fiscal and monetary policy seems to change and be difficult to predict. Nine months for monetary policy and two to nine months for fiscal policy are reasonable estimates.

We add all those together and the total lag is more than 14 months for monetary policy and a range of 15 to 58 months for fiscal policy. Given these time lags, the President, Congress, and the Fed cannot wait for events to happen. They instead must predict what the future holds and then make a decision to implement policy now. If we know that monetary policy takes 14 months before it begins to take effect, then we must forecast economic conditions 14 months from now and make a decision now to do something about it. It is even more challenging for fiscal policy. Unfortunately, economists are not very good at making those forecasts.

Table 26.3: Monetary Policy Versus Fiscal Policy​

Question 26.16

Question 26.16

Assume that the economy is at full employment level of real GDP and remains there. Also, assume that saving and net exports do not change. What is the actual cost of an increase in the federal budget deficit? Think opportunity cost here. Explain how you got your answer.

Hover here to see the hint for Question 26.16.
Click here to see the answer to Question 26.16.​

Question 26.17

Question 26.17

Assume that we are currently producing less than the potential level of GDP. What are legitimate arguments against actually using monetary or fiscal policy?

Hover here to see the hint for Question 26.17.
Click here to see the answer to Question 26.17.

26.10​ Summary

  • ​Fiscal policy is the deliberate change in spending and taxes by the federal government in efforts to influence economic conditions in the economy.
  • Changes in spending and taxes for other reasons (for example, to expand education or to lower taxes on certain types to income) will also have unintended effects on economic conditions.
  • To stimulate spending in an economy, a government can lower taxes, increase government spending on goods and services, or increase government transfer payments.
  • To slow growth in spending in an economy, a government can increase taxes, decrease government spending on goods and services, or decrease government transfer payments.
  • Changes in taxes and spending can also have effects on incentives and aggregate supply conditions in an economy. To increase aggregate supply, a government can lower taxes to increase incentives to work, save, and invest, or direct spending toward investment in physical and human capital and research and development.
  • Government deficits increasing as a percentage of GDP do have costs. The primary cost is the eventual crowding out of private investment and the eventual slower economic growth.
  • Government debt is the sum of all past government deficits and surpluses. Government finance deficits and debt by issuing government bonds.
  • Fiscal policy does have a significant lag between the recognition of the necessity to undertake a policy and the effects of that policy. The political decision-making process can create a very long lag. 

26.11 Key Concepts

​Fiscal policy
Government spending on goods and services
Policy Delays
Taxes
Transfer Payments
Surpluses, deficits, and debt – Measurement, myths, and meaning
Using fiscal and monetary policy together

26.12​ Glossary

Automatic stabilizers: Our system of income taxes and government transfer payments functions in a manner that reduces the effects on total spending of changes in consumption, investment, government spending on goods and services, and net exports.

Capital gain: An increase in the value of an asset.

Capital gains tax: A tax on the capital gain earned when an asset is sold.

Corporate profits tax: Federal government taxes on corporate profits.

Federal debt: The sum of all of the past federal budget deficits and surpluses.

Fiscal policy: Most often refers to deliberate actions by the federal government to change taxes and to spend with a goal of influencing economic conditions. Also includes tax and spending changes undertaken for other reasons.

Government budget deficit and surplus: Subtract spending on goods and services and transfer payments from revenues. If the result is a negative number, the government has a budget deficit. If it is a positive number, the government has a surplus.

Investment tax credit: A reduction (or credit) in a corporation’s tax, calculated as a percentage of the amount spent on investment.

Reaganomics: The income tax reductions passed while Ronald Reagan was President. The tax reductions were intended to increase productivity and investment, while at the same time not increasing the federal budget deficit.

Restrictive fiscal policy: A fiscal policy meant to reduce inflationary pressures. Normally an increase in taxes or a reduction in spending and transfer payments. Also referred to as contractionary fiscal policy.

Stimulative fiscal policy: A fiscal policy meant to reduce unemployment. Normally a decrease in taxes or an increase in spending and transfer payments. Also referred to as expansionary fiscal policy.

Supply-side tax cuts: Tax cuts that are intended to increase aggregate supply by increasing work effort, saving, and investment.

Transfer payments: Government payments to individuals, such as social security, welfare, and Medicare.


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Answer Key:


Answer to Question 26.10

The 2001 changes should have increased disposable income and thus increased consumption spending. The 2002 deduction of 30 percent of investment made investment on the part of business firms less expensive and thus should have increased investment spending. The extended unemployment benefits gave more income to unemployed individuals and should have increased consumption spending. The 2003 income tax changes should again have increased consumption spending. The reduced capital gains and dividend taxes should have encouraged saving.

Click here to return to Question 26.10.






Answer to Question 26.14

As the economy enters a recession, income tax receipts will automatically begin to fall. (Income decreases as spending falls. Since income tax receipts are a percentage of income, they decrease.) As revenues fall, a deficit is created. A required balanced budget would mean that we would have to raise taxes or reduce spending. That is exactly the wrong fiscal policy at the beginning of a recession and would make the recession much worse than it otherwise would be.

Click here to return to Question 26.14.






Answer to Question 26.16

​​In equilibrium, spending (C + I + G + NX) equals income. Income, by definition, equals C + S + T. Thus investment will equal private saving plus the government surplus (or deficit, if G is larger than T) minus net exports. I = S + (T - G) - NX. If the economy is at full employment and remains there and saving and net exports do not change, then an increase in the government deficit will mean that less saving is left over for investment.

Since investment must decrease, the opportunity cost of the increased government deficit is the forgone investment spending with its accompanying increased capacity to produce more goods and services in the future. (In the next chapter, the answer becomes a bit more involved as we consider the effects on net exports also. But the fundamental correctness of this answer remains.)

Click here to return to Question 26.16.






Answer to Question 26.17

​There are several possibilities. Here are two key components:

        1. The economy left alone will eventually return to the potential level as wages fall.
        2. The use of monetary or fiscal policy will cause higher prices at full employment than if we just let the economy adjust on its own.

or

If we use active policy, we may make a mistake given forecasting difficulties, lag times, and the tendency to stimulate the economy too much.

or

If the cause of the short-run equilibrium below full-employment output is a negative supply shock, then the active use of monetary and fiscal policy will make one already bad problem worse.

Click here to return to Question 26.17.


Data sources:

Figure 26.9

Interactive Graphs

Figure 26.11 Caption

Footnote:

1 The estimate of poverty reduction associated with Social Security can be found in Engelhardt and Gruber (2004) http://www.nber.org/papers/w10466.

Image Credits:

[1] Image courtesy of unknown in the Public Domain.

[2] Image courtesy of the Congressional Budget Office.


Most often refers to deliberate actions by the federal government to change taxes, spending on goods and services, and transfer payments with a goal of influencing economic conditions. Fiscal policy also includes tax and spending changes undertaken for other reasons.
A government surplus occurs when government spending is less than revenue. A government deficit occurs when government spending exceeds revenue.
Tax cuts that are intended to increase aggregate supply by increasing work effort, saving, and investment.
A tax on increases in asset values, currently a 15 percent tax on gains of assets held over one year for most taxpayers.
Ask yourself whether these tax changes affected consumers or businesses.
Automatic stabilizers are taxes or spending programs that automatically stimulate the economy during recessions and that restrict spending during expansions.
The sum of all of the past federal budget deficits and surpluses.
Subtract spending on goods and services and transfer payments from revenues. If the result is a negative number, the government has a budget deficit. If it is a positive number, the government has a surplus.
Begin by asking what happens to government revenues as the recession begins.
Think about the savings-investment equality in equilibrium.
Consider the effects of monetary policy on output, interest rates, and prices.