Chapter 17: Fiscal Policy and the Federal Budget

Fiscal Policy -- the Federal government changing its government budget position (G - T) in order to stabilize the economy.

Fiscal Policy, by its nature, alters the Federal Budget. This chapter also examines the Federal Budget, what it’s made up of, and when budget deficits can be a problem in the economy.

The Federal Budget

Federal Budget (or Budget) = Tax Revenues - Government Expenditure (over a given period).

Federal Budget (or Budget) = Tax Revenues - (Government Purchases of Goods and Services + Transfer Payments + Interest on the National Debt).

Budget Definitions

Budget < 0 -- Budget DeficitBudget > 0 -- Budget SurplusBudget = 0 -- Balanced Budget

Realistic Goal -- Balanced Budget when Y = YF.

The US Federal Budget: 2003 (Billions of Dollars)

Tax Revenues $1974.8Government Expenditure $2381.3Federal Budget -$406.5

Source: Economic Indicators, October 2005.

Breakdown of Tax Revenues

Personal Income Taxes = $801.8Corporate Profits Taxes = $217.4Taxes on Production and Imports (e.g. sales and excise taxes) = $94.0Contributions for Social Insurance = $803.5Other = $58.1

Breakdown of Government ExpenditurePurchases of Goods and Services (G) = $725.7Transfer Payments = $1391.2Interest Payments = $221.5Other = $42.9

Source: Economic Indicators, October 2005.

The Budget: In Our Notation

Recall variable definitions: -- T = net taxes = tax revenues - (transfer payments + interest on the national debt) -- G = government purchases of goods and services

The Budget and The Budget Position

Budget = T - GBudget Position (or size of deficit)

= G - T

The National Debt

The National Debt -- The total accumulated stock of debt owed by the government to its lenders (holders of government bonds).

Expanded by budget deficits, reduced by budget surpluses.

National Debt -- Realistic Goal

Realistic Goal -- consider the Debt-Income Ratio = (National Debt)/(GDP).For the US in 2004 = ($4295.5)/($11734.3) = 0.366.Source: Economic Indicators,

October 2005.

The Income Tax and Automatic Stabilization

Automatic Stabilization -- due to the income tax system, tax revenues change in directions that help to stabilize the economy, without any change in the tax structure (i.e. fiscal policy).

The Income Tax as an Automatic Stabilizer

Y* (maybe > YF) Tax Revenues

helps to cool the economy

Y* (maybe < YF) Tax Revenues

helps to stimulate the economy

Note -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

The Income Tax and the Federal Budget

Y* Tax Revenues T (T - G)A strong and growing economy

improves the budget.

Y* Tax Revenues T (T - G) A weak economy generates a lower

budget.

Strategy of Fiscal Policy

Expansionary policies seek to induce more purchasing of goods and services by increasing (G - T) -- i.e. G or T.

Contractionary policies seek to induce less purchasing of goods and services by decreasing (G - T) -- i.e. G or T.

Specific Types of Fiscal Policy

Change Government Purchases of Goods and Services (G)

-- Expansionary: G -- Contractionary: GChange Transfer Payments (TP)

-- Expansionary: TP -- Contractionary: TP

Tax Policy as Fiscal PolicyChange Marginal Tax Rates (t)

-- Expansionary: t -- Contractionary: t

Change Tax Deductions -- Expansionary: Bigger Deductions

-- Contractionary: Smaller DeductionsChange Indirect Business Taxes

(e.g. Sales or Excise Taxes) -- Expansionary: Lower Taxes -- Contractionary: Raise Taxes

Fiscal Policy in the AD-AS ModelExpansionary Fiscal Policy shifts the

AD curve rightward, increases Y* and P*.

Contractionary Fiscal Policy shifts the AD curve leftward, decreases Y* and P*.

Note -- like monetary policy, fiscal policy is justified only from a short-run perspective.

Obstacles to Fiscal Policy EffectivenessDifficulties in getting the proper

policy passed through Congress and the president.

A tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*.

Worries about the Federal Budget within a sluggish economy.

The Crowding Out Effect -- An Adverse “Side Effect”

The Crowding Out Effect -- Expansionary fiscal policy creates an increased need for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

The Crowding Out Effect -- Fiscal Policy Effectiveness

Crowding Out Effect -- makes fiscal policy less effective than would be otherwise.

Decrease in investment to some extent offsets rise in (G - T).

Smaller shift in AD curve than would be without the crowding out effect.

The Crowding Out Effect – Impeding Economic Growth

Crowding Out Effect loss of Investment (I).

Decrease in Investment retards the buildup of the capital stock and possible implementation of new technology (i.e. Labor Productivity growth).

Smaller shifts in LAS curve, smaller increases in YF.

Ways to Avoid the Crowding Out Effect

Bottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs.

-- expansionary monetary policy

-- increased private saving

-- increase in foreign capital

inflows

Distinctive Fiscal Policy Actions in the USWorld War IIThe Kennedy-Johnson Tax Cut of 1964The Nixon Tax Increase of 1969The Reagan Economic Recovery and

Tax Act of 1981Clinton Tax Increases of 1993Bush Tax Cuts of 2001-03Bush Tax Rebates of 2008Obama Fiscal Stimulus Plan of 2009