Economics NINTH EDITION Chapter 10 Fiscal Policy Prepared by Brock Williams Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved Learning Objectives 10.1 Explain how fiscal policy works using aggregate demand and aggregate supply 10.2 Identify the main elements of spending and revenue for the U.S federal government 10.3 Discuss the key episodes of active fiscal policy in the U.S since World War II Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved Fiscal Policy • Fiscal policy Changes in government taxes and spending that affect the level of GDP Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.1 THE ROLE OF FISCAL POLICY(1 of 5) Fiscal Policy and Aggregate Demand Panel A shows that an increase in government spending shifts the aggregate demand curve from AD0 to AD1, restoring the economy to full employment This is an example of expansionary policy Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD0 to AD1, restoring the economy to full employment This is an example of contractionary policy Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.1 THE ROLE OF FISCAL POLICY(2 of 5) Fiscal Policy and Aggregate Demand • Expansionary policies Government policy actions that lead to increases in aggregate demand • Contractionary policies Government policy actions that lead to decreases in aggregate demand Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.1 THE ROLE OF FISCAL POLICY(3 of 5) The Fiscal Multiplier • As the government develops policies to stabilize the economy, it needs to take the multiplier into account • The total shift in aggregate demand will be larger than the initial shift As we will see later in this chapter, • U.S policymakers have taken the multiplier into account as they have developed policies for the economy The Limits to Stabilization Policy • Stabilization policies Policy actions taken to move the economy closer to full employment or potential output Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.1 THE ROLE OF FISCAL POLICY(4 of 5) The Limits to Stabilization Policy LAGS Panel A shows an example of successful stabilization policy The solid line represents the behavior of GDP in the absence of policies The dashed line shows the behavior of GDP when policies are in place Successfully timed policies help smooth out economic fluctuations Panel B shows the consequences of ill-timed policies Again, the solid line shows GDP in the absence of policies and the dashed line shows GDP with policies in place Notice how ill-timed policies make economic fluctuations greater Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.1 THE ROLE OF FISCAL POLICY(5 of 5) The Limits to Stabilization Policy LAGS • Inside lags The time it takes to formulate a policy • Outside lags The time it takes for the policy to actually work FORECASTING UNCERTAINTIES What makes the problem of lags even worse is that economists are not very accurate in forecasting what will happen in the economy Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION INCREASING LIFE EXPECTANCY AND AGING POPULATIONS • SPUR COSTS OF ENTITLEMENT PROGRAMS APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing costs for their government programs? • • Today, Social Security, Medicare, and Medicaid constitute approximately 10 percent of GDP Experts estimate that in 2075 spending on these programs will be approximately 22 percent of GDP How will our society cope with increased demands for these services? Possible solutions: • • • • Leave the existing programs in place and just raise taxes to pay for them The government should save and invest now to increase GDP in the future to reduce the burden on future generations Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being Reform the health-care system to encourage more competition to reduce health-care expenditures Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (1 of 8) Federal Spending Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (2 of 8) Federal Spending • Discretionary spending The spending programs that Congress authorizes on an annual basis • Entitlement and mandatory spending Spending that Congress has authorized by prior law, primarily providing support for individuals Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (3 of 8) Federal Spending • Social Security A federal government program to provide retirement support and a host of other benefits • Medicare A federal government health program for the elderly • Medicaid A federal and state government health program for the poor Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (4 of 8) Federal Revenues Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (5 of 8) Federal Revenues SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE • Supply-side economics A school of thought that emphasizes the role that taxes play in the supply of output in the economy • Laffer curve A relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (6 of 8) The Federal Deficit and Fiscal Policy • Budget deficit The amount by which government spending exceeds revenues in a given year • Budget surplus The amount by which government revenues exceed government expenditures in a given year Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (7 of 8) Automatic Stabilizers The increased federal budget deficit works through three channels: Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income Because incomes not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much Because the corporation tax depends on corporate profits and profits fall in a recession, taxes on businesses also fall Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession • Automatic stabilizers Taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.2 THE FEDERAL BUDGET (8 of 8) Are Deficits Bad? • No – Automatic Stabilizers • Yes – Crowding Out PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION THE CONFUCIUS CURVE? APPLYING THE CONCEPTS #2: How are tax rates and tax revenues related? • While the idea that cutting tax rates might actually increase tax revenue is often attributed to economist Arthur Laffer, in fact, it is actually a much older idea than that • Yu Juo, one of the twelve wise men who succeeded Confucius in ancient China, was asked what should be done in the case of a famine if the government had insufficient funds He replied that the tax rate should be cut to 10 percent Skeptical government bureaucrats did not have enough funds at a 20 percent rate, so how could they cut it to 10 percent? • Yu Juo replied, “Cutting taxes and limiting your expenses allow people to raise their standard of living Afterwards, you will no longer need to worry about famine and shortage.” • Revenue estimators in Washington, D.C, not share entirely in Yu Juo’s wisdom, but they recognize that cutting tax rates will stimulate economic activity Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.3 FISCAL POLICY IN U.S HISTORY (1 of 4) The Depression Era During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits According to Brown, fiscal policy was expansionary only during two years of the Great Depression, 1931 and 1936 The Kennedy Administration Although modern fiscal policy was not deliberately used during the 1930s, the growth in military spending at the onset of World War II in 1941 increased total demand in the economy and helped pull the economy out of its long decade of poor performance But to see fiscal policy in action, we need to turn to the 1960s It was not until the presidency of John F Kennedy during the early 1960s that modern fiscal policy came to be accepted Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.3 FISCAL POLICY IN U.S HISTORY (2 of 4) The Vietnam War Era • Permanent income An estimate of a household’s long-run average level of income The Reagan Administration The tax cuts enacted during 1981 at the beginning of the first term of President Ronald Reagan were significant However, they were not proposed to increase aggregate demand Instead, the tax cuts were justified on the basis of improving economic incentives and increasing the supply of output Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.3 FISCAL POLICY IN U.S HISTORY (3 of 4) The Clinton, George W Bush, and Obama Administrations • At the beginning of his administration, President Bill Clinton proposed a “stimulus pachage” that would increase aggregate demand, but was defeated by Congress • Later, President Clinton, along with a Republican-controlled Congress, passed a major tax increase to balance the budget and brought the Federal budget into surplus • In 2001, President George W Bush passed a 10-year tax cut plan in part to stimulate the economy • After September 11, 2001, President Bush and Congress authorized new spending to stimulate the economy which had entered a recession • • This was followed by other expansionary fiscal policy In 2009, President Obama and Congress enacted the largest stimulus package in U.S history • The stimulus was controversial in both size and composition Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION HOW EFFECTIVE WAS THE 2009 STIMULUS? APPLYING THE CONCEPTS #3: Was the fiscal stimulus in 2009 successful? In 2009, President Obama signed into law the American Recovery and Reinvestment Act, the largest fiscal stimulus in United States history Although the recovery of the economy from the 2007 recession was still sluggish, many economists—including those at the Congressional Budget Office—believe that the stimulus did have a significant impact on the economy But not all economists share this belief James Feyrer and Bruce Sacerdote found that additional spending on infrastructure and support for low-income households was successful in generating economic activity, but spending on education was not John Taylor found little evidence that the temporary tax cuts stimulated consumption; they were essentially saved Taylor believes the stimulus was ineffective Others disagreed suggesting that without the aid to state and local governments, there would have been more substantial cuts in spending on local services Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10.3 FISCAL POLICY IN U.S HISTORY (4 of 4) In late 1990’s, tax increases, limited government spending, and economic growth which increased revenues resulted in the U.S experienced a surplus Tax cuts and stimulus packages designed to stimulate the economy after the recessions of 2001 and 2008 resulted in U.S deficits again Source: Congressional Budget Office, January 2015 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved KEY TERMS Automatic stabilizers Medicare Budget deficit Outside lags Budget surplus Permanent income Contractionary policies Social Security Discretionary spending Stabilization policies Entitlement and mandatory spending Supply-side economics Expansionary policies Fiscal policy Inside lags Laffer curve Medicaid Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved ... Objectives 10. 1 Explain how fiscal policy works using aggregate demand and aggregate supply 10. 2 Identify the main elements of spending and revenue for the U.S federal government 10. 3 Discuss... taxes and spending that affect the level of GDP Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 10. 1 THE ROLE OF FISCAL POLICY(1 of 5) Fiscal Policy and Aggregate Demand... Rights Reserved 10. 1 THE ROLE OF FISCAL POLICY(2 of 5) Fiscal Policy and Aggregate Demand • Expansionary policies Government policy actions that lead to increases in aggregate demand • Contractionary