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Fiscal Policy
Government spending, tax, and Government spending, tax, and budget balancebudget balance
Government Spending: GGovernment Spending: G Government Revenue: TaxGovernment Revenue: Tax
Government spending, tax, and Government spending, tax, and budget balancebudget balance
Deficit = G - T Deficit = G - T
Two fiscal components in AE: Two fiscal components in AE: G and T G and T
AE = C + I + G + X - IMAE = C + I + G + X - IM
= a + b (Y - T ) + I + G + X - IM= a + b (Y - T ) + I + G + X - IM
TaxTax
Lump-sum TaxLump-sum Tax– is a fixed amount tax, regardless of the is a fixed amount tax, regardless of the
GDP level.GDP level. Income Tax Income Tax
– Depends on the income levelDepends on the income level
Lump-sum Tax and its effect on AELump-sum Tax and its effect on AE
A parallel shift in the AE lineA parallel shift in the AE line
Consumption function in the Y-C Space
C
Y (GDP)
C
0
C = ( a – bT) + b Y
a – bT
Changes in T
C’
AE in the AE-Y space
0 Y
AE = C + I + G + X - IM
AE
cut in T
Example of a Model economy Example of a Model economy
C = 360 + 0.8 DIC = 360 + 0.8 DI
I = 300I = 300
G = 200G = 200
X - IM = 0X - IM = 0
T = 200T = 200 Assume that the potential GDP is Assume that the potential GDP is
40004000
Example of a Model economyExample of a Model economy
Assume prices are fixed, what is the Assume prices are fixed, what is the equilibrium level of Y?equilibrium level of Y?
AE =360+0.8(Y-200)+300+200+0 AE =360+0.8(Y-200)+300+200+0
= 0.8 Y + 700= 0.8 Y + 700
Y = AE = 0.8 Y + 700Y = AE = 0.8 Y + 700
(1-0.8) Y = 700(1-0.8) Y = 700
Y* = 1/(1-0.8) X 700 = 5 X 700 Y* = 1/(1-0.8) X 700 = 5 X 700
= 3500= 3500
Example of a Model economy Example of a Model economy
Assume that the potential GDP is Assume that the potential GDP is 40004000
But the current output is 3500But the current output is 3500 Hence the recessionary gap is 500Hence the recessionary gap is 500
Cut in Tax (lump-sum tax)
0 Y
AE
AE
Cut in T
AE’
Cut in Tax (lump-sum tax)
0 Y
AE
AE
Cut in T
AE’
45 degree line
Y’Y*
Tax multiplierTax multiplier
Tax multiplierTax multiplierY* Y*
TT = ------ = ------TT
How big is the tax multiplier?How big is the tax multiplier?
ET MPCG
YMPC
T
Y
Tax multiplierTax multiplier
For the oversimplified versionFor the oversimplified version
MPC
MPC
MPCMPC
T
YT
11
1
Effect of Tax Change on AEEffect of Tax Change on AE
The magnitude of shift in AE by a tax The magnitude of shift in AE by a tax cut is smaller as compared with cut is smaller as compared with increase in Gincrease in G
Why is smaller? Why is smaller? Leakage from savingLeakage from saving
ExampleExample
Suppose instead of increasing the Suppose instead of increasing the spending, the government decides to spending, the government decides to cut the tax to close the recessionary cut the tax to close the recessionary gap. By how much cut in tax can the gap. By how much cut in tax can the government close the gap?government close the gap?
Example of a Model economy Example of a Model economy
Assume that the potential GDP is Assume that the potential GDP is 40004000
But the current output is 3500But the current output is 3500 Hence the recessionary gap is 500Hence the recessionary gap is 500 Objective: close this recessionary Objective: close this recessionary
gap to achieve the full employmentgap to achieve the full employment Two options: increase G or Cut in T.Two options: increase G or Cut in T.
Example of a Model economy Example of a Model economy
Two options: increase G or cut in T.Two options: increase G or cut in T. If increase in G, how much?If increase in G, how much? If cut in T, how much?If cut in T, how much?
Example of a Model economy Example of a Model economy
Increase in G.Increase in G. What is the expenditure multiplier?What is the expenditure multiplier? MPC = 0.8 so expenditure MPC = 0.8 so expenditure
multiplier is 5multiplier is 5 Increase G by 100 would lead to an Increase G by 100 would lead to an
increase in Y by 500, and close the increase in Y by 500, and close the recessionary gap.recessionary gap.
Example of a Model economy Example of a Model economy
Cut in TCut in T What is the tax multiplier: -4What is the tax multiplier: -4
Tax multiplierTax multiplier
11 1 1 T = - MPC X --------- = - 0.8 X -------- = -4 T = - MPC X --------- = - 0.8 X -------- = -4
1 - MPC1 - MPC 1- 0.8 1- 0.8
To increase GDP by 500, we need tax cut byTo increase GDP by 500, we need tax cut by
500 / -4 = - 125 500 / -4 = - 125
Balanced budget multiplierBalanced budget multiplier
If the government If the government simultaneously increases its simultaneously increases its spending and tax by the same spending and tax by the same amount so as to leave the balance amount so as to leave the balance unchanged, will there be an impact unchanged, will there be an impact on the equilibrium GDP?on the equilibrium GDP?
--- a net effect on GDP--- a net effect on GDP
Income TaxIncome Tax
Depends on the income. It increases Depends on the income. It increases as income increasesas income increases
Income tax rate = tIncome tax rate = t Its effect on AEIts effect on AE
The slope of AE changes as tax The slope of AE changes as tax rate changesrate changes
Cut in in tax rate
0 Y
AE’
AE
increase in t
AEt = 0
t = 0.20
b ( 1-t)
Cut in tax rate
0 Y
AE
AE
Cut in t
AE’
45 degree line
Y’Y*
Income TaxIncome Tax
Equation formEquation formLet the income tax rate = tLet the income tax rate = tTax isTax isT = tYT = tY
Consumption Consumption C = a + b DIC = a + b DI
= a + b (Y - tY)= a + b (Y - tY) = a + b (1-t) Y= a + b (1-t) Y
Example Example
ModelModel
C = 360 + 0.8 DIC = 360 + 0.8 DI
I = 300I = 300
G = 200G = 200
X - IM = 0X - IM = 0 With income tax rateWith income tax rate
t = 0.25t = 0.25
Income Tax ModelIncome Tax Model
Solve for equilibrium YSolve for equilibrium YC = 360 + 0.8 ( 1- 0.25 ) YC = 360 + 0.8 ( 1- 0.25 ) Y = 360 + 0.6 Y= 360 + 0.6 Y
AE = 360 + 0.6 Y + 300 + 200 AE = 360 + 0.6 Y + 300 + 200 = 860 + 0.6 Y= 860 + 0.6 Y
Notice that the slope of AE is flatter.Notice that the slope of AE is flatter. Y* = 1 / (1-0.6) X 860 Y* = 1 / (1-0.6) X 860
= 2.5 X 860 = 2150= 2.5 X 860 = 2150
Notice the expenditure multiplier Notice the expenditure multiplier becomes 2.5, which is smaller. becomes 2.5, which is smaller.
Income taxIncome tax
With income tax, the multiplier is With income tax, the multiplier is smaller because at each round of the smaller because at each round of the “trickling-down” process, there is a “trickling-down” process, there is a leakage of income tax paid.leakage of income tax paid.
This another reason why we called This another reason why we called 1/(1-MPC) oversimplified multiplier.1/(1-MPC) oversimplified multiplier.
Why changes in T is Why changes in T is less effective than Gless effective than G
in economic recessionin economic recession
Why changes in T is less effective Why changes in T is less effective than G in stimulating economy in than G in stimulating economy in economic recession?economic recession?
Tax multiplier is smallerTax multiplier is smaller Consumption is insensitive to a tax Consumption is insensitive to a tax
cut so long as people remain cut so long as people remain pessimistic about futurepessimistic about future
Difficulties to design a precise Difficulties to design a precise policy policy
All the variables are changing day by All the variables are changing day by day;day;
the precise value of MPC is unknown,the precise value of MPC is unknown, the precise value of Yp is unknown,the precise value of Yp is unknown, the time lag for the policy to take the time lag for the policy to take
effect is unknown,effect is unknown, the shape of AS is unknown thus the the shape of AS is unknown thus the
inflation side-effect caused by the inflation side-effect caused by the expansionary tax policy is unknown.expansionary tax policy is unknown.
Twin deficitsTwin deficits
The trade deficit is related to our The trade deficit is related to our budget deficitbudget deficit
We have $500 billion trade deficit, We have $500 billion trade deficit, and $1.5 trillion budget deficit.and $1.5 trillion budget deficit.
Breakdown of the deficit
Breakdown of the deficit• Compared with the October-June period of fiscal 2008, during the
first nine months of fiscal 2009: • --Revenues plunged $345 billion, or 17.8 percent; • --Spending soared $455 billion, or 20.5 percent; • --Defense spending increased 7.5 percent to $474 billion; • --Spending on food stamps increased 36.8 percent to $40 billion; • --Medicaid spending increased 23 percent to $186 billion; • --Unemployment benefits increased 165 percent to $77 billion; • --The Troubled Asset Relief Program, which began in October, has
cost taxpayers an estimated $147 billion; • --Bailing out Fannie Mae and Freddie Mac has cost $85 billion.
Twin deficitsTwin deficits
Y = C + I + G + (X - IM)Y = C + I + G + (X - IM) Y = C + S + TY = C + S + T
Combine the two accounting identities, we Combine the two accounting identities, we havehave
C + I + G + (X - IM) = C + S + TC + I + G + (X - IM) = C + S + T IM - X = (G – T) + (I – S) IM - X = (G – T) + (I – S) Trade deficitTrade deficit
= Government budget deficit = Government budget deficit
+net private saving deficiency+net private saving deficiency
How should we reduce trade deficitHow should we reduce trade deficit
Government budget deficit Government budget deficit
= net private saving + trade = net private saving + trade deficitdeficit
According to the twin deficits model, According to the twin deficits model, we need to reduce the government we need to reduce the government budget deficit G - Tbudget deficit G - T
You either cut the government You either cut the government spending or raising taxspending or raising tax
How should we reduce trade deficitHow should we reduce trade deficit
According to the Keynesian theory According to the Keynesian theory (the balance budget multiplier) (the balance budget multiplier) raising tax is probably the better idea raising tax is probably the better idea to balance the budget but stimulate to balance the budget but stimulate the economythe economy
But there is a big political hurdle to But there is a big political hurdle to raise tax.raise tax.
Health reform bill and budgetHealth reform bill and budget
According to the Congressional According to the Congressional Budget Office’s estimate, the bill will Budget Office’s estimate, the bill will cut the budget deficit by 138 billion cut the budget deficit by 138 billion dollars a year.dollars a year.
CBO is a non-partisan, independent CBO is a non-partisan, independent office, reporting to the Congress. office, reporting to the Congress. The Republicans also cite often the The Republicans also cite often the figures by CBO to criticize figures by CBO to criticize Democrats.Democrats.
Supply-side economicsSupply-side economics
ReaganomicsReaganomics Supply-side economicsSupply-side economics Supply-side tax cutsSupply-side tax cuts Shift focus from AD to ASShift focus from AD to AS
Supply-side economicsSupply-side economics
Supply-side tax cutsSupply-side tax cuts cutting income tax to induce people cutting income tax to induce people
to work longer, and to work longer, and giving tax incentive to encourage giving tax incentive to encourage
investment and researchinvestment and research RemarksRemarks