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CHAPTER 11
Fiscal Policy and the Federal Budget
Chapter 11 analyzes the federal budget in terms of government expenditures and tax revenues,
and deficits and surpluses. Income tax structures and the public debt are also examined in this
chapter. The major focus of the chapter is on fiscal policy, beginning with some basic
definitions, then discussing demand-side and supply-side fiscal policy, and addressing both the
mechanics of fiscal policy and its effectiveness in stabilizing the economy.
 KEY IDEAS
1. The federal budget is composed of government expenditures and tax revenues.
2. The current federal income tax system is progressive.
3. The federal budget can be in deficit, in surplus, or in balance, and there can be a cyclical
deficit and a structural deficit.
4. The public debt is not the same as a federal budget deficit.
5. Some have proposed higher taxes or new taxes to deal with the enlarged budget deficits
and growing public debt.
6. One of the major ways government can influence the economy is through its fiscal
policy.
7. Fiscal policy can affect aggregate demand.
8. Sometimes crowding out effects occur which diminish the effectiveness of fiscal policy.
9. Lags can diminish the effectiveness of fiscal policy.
10. Fiscal policy effects can be felt on the supply side as well as on the demand side of the
economy.
 CHAPTER OUTLINE
I. THE FEDERAL BUDGET
The federal budget is composed of two, not necessarily equal, parts: government
expenditures and tax revenues. Government expenditures is the sum of government
purchases and (government) transfer payments.
186
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Fiscal Policy and the Federal Budget 187
A. Government Expenditures
In 2013, the federal government spent $3.685 trillion, which was 22.7 percent of
GDP for that year. Social security, Medicare, Medicaid, and national defense
accounted for about 61 percent of all federal government spending in 2013.
B. Government Tax Revenues
In 2013, government revenues totaled $2.712 trillion; this was equal to 16.7
percent of GDP for the year. The individual income tax, the corporate income tax,
Medicare (payroll) and Social Security (payroll) taxes accounted for 88 percent of
total government tax revenues for 2013.
C. Social Security, Medicare, and Medicaid in the Future
In the year 2050, if tax revenues as a percentage of GDP are expected to be 19

percent, then all of it will have to be spent on Social Security, Medicare, and
Medicaid; spending on these three programs is projected to be approximately 19
percent in 2050. The money to support national defense, education,
infrastructure, education, and other programs will have to be borrowed.
D. Budget Projections
This section presents the projections for government spending and tax revenues
from 2015 to 2019.
1. Income Tax Structures
An income tax structure can be progressive (the tax rate increases as a

person’s taxable income level rises), proportional (the same tax rate is
used for all income levels), or regressive (the tax rate decreases as a
person’s taxable income level rises).
2. Who Pays the Income Tax?
Economists often look at the tax situation for different income groups, as
shown in the text. For example, in 2011, the top 1 percent of income
earners in the U.S. earned 18.7 percent of the income earned that year
and paid 35.1 percent of the total federal income taxes collected.
E. Budget Deficit, Surplus, or Balance
If government expenditures are greater (less) than tax revenues, the federal
government runs a budget deficit (surplus). If government expenditures are equal
to tax revenues, the federal government runs a balanced budget. In 2013, the
federal government ran a budget deficit of $973 billion. The federal government
finances the budget deficit with borrowed funds.
F. An Interesting Fact: Taxing Millionaires and the Budget Deficit
188 Chapter 11
It is often believed that taxing the rich at a higher rate would help in reducing or
eliminating budget deficits. Two important questions to consider in this case
would be the rate at which the rich would have to be taxed to eliminate the
deficits and the number of years in which the deficit can be eliminated by taxing
the rich at a higher tax rate.
G. Structural and Cyclical Deficits
Economists use the term cyclical deficit to refer to the part of the budget deficit
that is a result of a downturn in economic activity. The part of the deficit that
would exist if the economy were operating at full employment is called the
structural deficit. The total budget deficit equals the sum of the structural and
cyclical deficits.
H. The Public Debt
The public debt is the total amount the federal government owes its creditors.
The public debt was $17.5 trillion on July 30, 2014. The public debt held by the
public was $12.5 trillion.
I. Value-Added Tax
Some economists have proposed higher taxes or new taxes to deal with the
enlarged budget deficits and growing public debt. One tax that has been
suggested is the value-added tax (VAT). Some have proposed VAT as a
supplementary revenue source; others, as a substitute for current taxes.
There are two things to understand about a value-added tax.
1. The Value-Added Part - Value added is the difference between what a

producer sells a (final) good for and what he pays for a (intermediate)
good. Two things to be noted here are the following:
a. The sum of the values added is equal to the price paid by the final
consumer.
b. The value added at each stage of production is equal to the dollar
amount kept by the seller of the good.
2. The Tax Part - A value-added tax (VAT) is a tax applied to the value
added at each stage of production. VAT generates tax revenue and it
raises prices.
A VAT generates the same amount of revenue as a sales tax of the same
amount, but critics stress the point that VAT is less visible than a sales tax,
making it hard for consumers to distinguish between the seller charging a higher
price because the VAT rate has been raised and the seller charging a higher
price even without the VAT rate being raised. The VAT critics add that when a
sales tax is raised, people look to government and say, “Government raised my
taxes.” When VAT is raised, people say, “Sellers raised the prices I pay.”
J. Tax Deductions vs Subsidies

A tax subsidy is not the same as a tax deduction. With a subsidy, money goes
from one person to another. If a company is being subsidized, the government
takes money from the taxpayers and gives it to the company receiving a subsidy.
A tax deduction occurs when the government reduces the taxes to be paid by a
company if the company does something like keeping its factories in the U.S.
II. FISCAL POLICY
One of the major ways government can influence the economy is through its fiscal
policy. Fiscal policy refers to changes in government expenditures and/or taxes to
achieve particular economic goals, such as low unemployment, price stability, and
economic growth.
A. Some Relevant Fiscal Policy Terms
Expansionary fiscal policy refers to increases in government expenditures and/or

decreases in taxes to achieve macroeconomic goals. Contractionary fiscal policy
refers to decreases in government expenditures and/or increases in taxes to
achieve these goals. Discretionary fiscal policy refers to changes in government
expenditures and taxes that are brought about deliberately through government
actions. Automatic fiscal policy refers to a change in either government
expenditures or taxes that takes place in response to economic events.
B. Two Important Notes
This chapter deals only with discretionary fiscal policy, and assumes that transfer
payments are constant so that changes in government spending are a reflection
of changes in government purchases only.
III. DEMAND-SIDE FISCAL POLICY
This section focuses on how government spending and taxes can affect aggregate
demand.
A. Shifting the Aggregate Demand Curve
An increase in government purchases (G) increases aggregate demand (AD)

and shifts the AD curve to the right. A decrease in G decreases AD and shifts the
AD curve to the left.
A change in taxes can affect consumption or investment or both and therefore

can affect aggregate demand. For example, a decrease in income taxes
increases disposable income, which permits individuals to increase their
consumption, increasing AD and shifting the AD curve to the right.
B. Fiscal Policy: Keynesian Perspective (Economy Is Not Self-Regulating)
190 Chapter 11
The Keynesian prescription for a recessionary gap is to enact expansionary fiscal

policy measures (an increase in government purchases or a decrease in taxes)
to shift the AD curve rightward to move the economy to the Natural Real GDP
level. The Keynesian prescription for an inflationary gap is to enact
contractionary fiscal policy measures (a decrease in government purchases or an
increase in taxes) to shift the AD curve leftward to move the economy to the
Natural Real GDP level.
C. Crowding Out: Questioning Expansionary Fiscal Policy
Some economists believe that crowding out effect reduces the effectiveness of
fiscal policy. Crowding out refers to a decrease in private expenditures that
occurs as a consequence of increased government spending or the financing
needs of a budget deficit. Crowding out can be direct or indirect.
When one dollar of government spending offsets one dollar of private spending,
complete crowding out is said to exist. Incomplete crowding out occurs when an
increase in government spending is only partially offset by a decrease in private
spending. Zero crowding out occurs if an increase in government spending is not
offset at all by a decrease in private spending. If complete or incomplete
crowding out occurs, fiscal policy will have less impact on aggregated demand
and Real GDP than Keynesian theory predicts. Exhibit 3 illustrates the
consequences of complete and incomplete crowding out.
D. Lags and Fiscal Policy
There are potentially significant time lags involved in the process of identifying
economic problems. Time lags may negate the effectiveness of discretionary
fiscal policy by making it take effect too late. In fact, if the policy takes effect late
enough, it may actually cause more problems than it solves.
There are five types of lags:
1. The Data Lag—the time between when a potential problem arises and when
policymakers notice it.
2. The Wait-and-See Lag—the time between when policymakers notice a

potential problem and when they decide it is worthy of action.
3. The Legislative Lag—the time it takes to get a policy action approved.
4. The Transmission Lag—the time required to put a policy into effect.
5. The Effectiveness Lag—the time the economy takes to respond once a

policy is put into effect.
E. Crowding Out, Lags, and the Effectiveness of Fiscal Policy
Economists who believe that the crowding out is zero and that lags are
insignificant conclude that fiscal policy is effective at moving the economy out of
a recessionary gap. Economists who believe that crowding out is complete
and/or that lags are significant conclude that fiscal policy is ineffective in this
respect.
F. Democracy in Deficit
In their book Democracy in Deficit, economists James Buchanan and Richard

Wagner pointed out that the unwritten balanced budget rule was cast aside with
the advent of the Keynesian revolution in economics. Although Keynesian
economics might argue for contractionary fiscal policy during an inflationary gap,
politics often trump economics and this would lead to a push for expansionary
fiscal policy even during an inflationary gap.
IV. SUPPLY-SIDE FISCAL POLICY
Fiscal policy effects may be felt on the supply side as well as the demand side of the
economy. Supply-side fiscal policy focuses on taxation issues.
A. Marginal Tax Rates and Aggregate Supply
When fiscal policy measures affect tax rates, they may affect the SRAS curve as
well as the AD curve. Ceteris paribus, lower marginal tax rates (= Δ tax payment/
Δ taxable income) increase the incentive to engage in work relative to leisure and
tax-avoidance activities. As resources shift from leisure to work, short-run AS
increases. If the lower marginal tax rates are permanent, then most economists
predict that the long-run AS curve will shift to the right as well.
B. The Laffer Curve: Tax Rates and Tax Revenues
The Laffer Curve shows the relationship between tax rates and tax revenues.
According to Laffer, as tax rates rise from zero, tax revenues rise, reach a
maximum point, and then fall as the tax rate continues to rise. Tax revenues are
a function of the tax rate and the tax base, as shown in the equation:
Tax revenues = Tax base x (average) Tax rate
Whether tax revenues increase or decrease as the average tax rate is lowered
depends on whether the tax base expands by a greater or lesser percentage
than the percentage reduction in the tax rate. It is possible for tax revenues to
increase if (marginal) income tax rates are reduced.
C. Fiscal Policy and Expectations
Tax rate changes may not induce changes in people’s behaviors if they expect
even larger tax rate changes in the future.
 TEACHING ADVICE
192 Chapter 11
1. For more information about the fiscal gap, read Alan J. Auerbach and William G. Gale,
“The Economic Crisis and the Fiscal Crisis: 2009 and Beyond,” available at
http://www.brookings.edu/~/media/Files/rc/papers/2009/0219_fiscal_future_gale/0219_fi
scal_future_gale.pdf.
2. One example of a tax cut that led to an increase in tax revenues is discussed in “An
Urban Tax Revolt,” The Wall Street Journal, 4/9/2002, which discusses a payroll tax cut
in Philadelphia that led to a 19% increase in wage-tax revenues.
3. Students may find it interesting and relevant to know that the third person dining with
Arthur Laffer and the journalist when Arthur Laffer first drew his curve on a napkin was
future Vice President (and then Deputy White House Assistant) Richard Cheney. See
Alan Murray, “’Dynamic’ Scoring Finally Ends Debate on Taxes, Revenue” The Wall
Street Journal, 4/1/2003.
 ASSIGNMENTS FOR MASTERING KEY IDEAS

Assignment 11.1
Key Idea: The federal budget is composed of government expenditures and tax revenues.
1. List the major federal government spending programs.
2. List the major federal government taxes.
Assignment 11.2
Key Idea: The current federal income tax system is progressive.
1. Compare a proportional tax system, a progressive tax system, and a regressive tax
system.
Assignment 11.3
Key Idea: The federal budget can be in deficit, in surplus, or in balance, and there can be a
cyclical and a structural deficit.
1. Explain when each of the following would occur:
a. Budget deficit.
b. Budget surplus.
c. Balanced budget.
d. Cyclical deficit.
e. Structural deficit.
Assignment 11.4
Key Idea: The public debt is not the same as a federal budget deficit.
1. Define the public debt.
Assignment 11.5
Key Idea: Some have proposed higher taxes or new taxes to deal with the enlarged budget
deficits and growing public debt.
1. Define value-added tax (VAT).
2. Explain why some critics prefer a sales tax to a VAT.
Assignment 11.6
Key Idea: One of the major ways government can influence the economy is through its fiscal
policy.
1. Define the following terms:

a. Fiscal policy
b. Expansionary fiscal policy
c. Contractionary fiscal policy
d. Discretionary fiscal policy
e. Automatic fiscal policy
Assignment 11.7
Key Idea: Fiscal policy can affect aggregate demand.
1. Explain how changes in government purchases and taxes affect aggregate demand.
2. Describe the Keynesian prescription to cure a recessionary gap.
3. Describe the Keynesian prescription to cure an inflationary gap.
Assignment 11.8
Key Idea: Sometimes crowding out effect occurs which diminishes the effectiveness of fiscal
policy.
1. Explain how direct substitution of public services for consumer spending can create a
crowding out effect.
2 Explain how government borrowing can lead to interest rate changes that create a
crowding out effect.
Assignment 11.9
Key Idea: Lags can diminish the effectiveness of fiscal policy.
1. Name and describe the five types of lags.
2. Explain why lags are problems.
Assignment 11.10
Key Idea: Fiscal policy effects can be felt on the supply side as well as on the demand side of
the economy.
1. Describe how lowering marginal income tax rates will affect aggregate supply.
2. Describe the Laffer Curve, and use it to explain how lower marginal tax rates can lead to
higher tax revenues.
 ANSWERS TO ASSIGNMENTS FOR MASTERING KEY IDEAS

Assignment 11.1 Answers
1. The major federal government spending programs include Social Security, Medicare,
Medicaid, and national defense.
2. The major federal government taxes are the individual income tax, the corporate income
tax, and social security taxes.

1. The tax rate is constant as income rises under a proportional tax system, rises as
income rises under a progressive tax system, and falls as income rises under a
regressive tax system.

1. a. A budget deficit would occur if government expenditures exceeded tax revenues
in a given fiscal year.
194 Chapter 11
b. A budget surplus would occur if government expenditures were less than tax
revenues in a given fiscal year.
c. A balanced budget would occur if government expenditures equaled tax
revenues in a given fiscal year.
d. A cyclical deficit is the part of the federal budget deficit that occurs as a result of
an economic downturn.
e. A structural deficit is the part of the federal budget deficit that would exist if the
economy were operating at full employment.

1. The public debt is the total amount the federal government owes its creditors.

1. A value-added tax (VAT) is a tax applied to the value added at each stage of production.
2. Critics stress the point that VAT is less visible than a sales tax, making it hard for
consumers to distinguish between the seller charging a higher price because the VAT
rate has been raised and the seller charging a higher price even without the VAT rate
being raised.

1. a. Fiscal policy refers to changes in government expenditures and/or taxes to
achieve particular economic goals.
b. Expansionary fiscal policy refers to increases in government expenditures and/or
decreases in taxes to achieve particular economic goals.
c. Contractionary fiscal policy refers to decreases in government expenditures
and/or increases in taxes to achieve particular economic goals.
d. Discretionary fiscal policy occurs when changes in government expenditures and
taxes are brought about deliberately through government actions.
e. Automatic fiscal policy occurs when a change in either government expenditures
or taxes takes place in response to economic events.

1. An increase in G increases AD and shifts the AD curve rightward. An increase in taxes
can affect consumption or investment or both and therefore shift AD. For example, a
decrease in income taxes increases disposable income, which leads to an increase in
consumption and shifts the AD curve rightward.
2. The Keynesian prescription to cure a recessionary gap would be to increase government
purchases or decrease taxes to shift the AD curve rightward to eliminate the gap.
3. The Keynesian prescription to cure an inflationary gap would be to decrease government
purchases or increase taxes to shift the AD curve leftward to eliminate the gap.

1. One illustration of direct substitution of public services for consumer spending would be
if the government buys $60 worth of gasoline for you, you decide to cut back your own
spending (on gasoline and all other goods) by $60. In this case, there is a direct
substitution of government purchases for consumer spending.
2 If, as a consequence of deficit spending, the government borrows more funds, the
interest rate will rise and investment spending will decline. The drop in investment
spending offsets the government spending.

1. The five types of lags include the data lag (policymakers are not aware of changes in the
economy as soon as they happen); the wait-and-see lag (policymakers rarely enact
counteractive measures immediately); the legislative lag (it can take months for
policymakers to propose a fiscal policy measure, build support for it, and get it passed);
the transmission lag (fiscal policy measures take time to be put into effect); and the
effectiveness lag (after a policy measure is implemented, it takes time to affect the
economy).
2. Lags are problems since, by the time the full impact of the policy is felt, the economic
problem it was designed to solve may no longer exist, may not exist to the degree it
once did, or may have changed altogether.

1. Lowering marginal tax rates increase incentives to work, increasing short-run aggregate
supply. If the lower marginal tax rates are permanent, the long-run aggregate supply
curve will shift rightward too.
2. The Laffer Curve shows the relationship between marginal income tax rates and total tax
revenue. According to the Laffer Curve, as tax rates rise from zero, tax revenues rise,
reach a maximum point, and then fall as the tax rate continues to rise. Therefore,
depending on where on the Laffer Curve the economy is located, it is possible that if the
government lowers marginal income tax rates, tax revenue will actually rise.
 ANSWERS TO VIDEO QUESTIONS AND PROBLEMS
1. Explain the difference between zero, incomplete, and complete crowding out. If
crowding out is complete, does it call into question the effectiveness of a rise in
government purchases in order to remove an economy from a recessionary gap?
Explain and diagrammatically represent your answer.
Zero crowding out: The government increases spending but private sector spending remains
constant.
Incomplete crowding out: The government increases spending and there is a less than
proportionate decrease in private sector spending.
Complete crowding out: The government increases spending and there is an equal decrease in
private spending.
196 Chapter 11
LRAS
SRAS
Price Level
1
AD1
0 Q1 QN Real GDP
In the above figure, the economy is in a recessionary gap at point 1. A fall in private
expenditures completely offsets the initial increase in aggregate demand due to increased
government spending. The aggregate demand curve does not move (on net) at all. Real GDP
does not change, and neither does the unemployment rate. So, with complete crowding out,
expansionary fiscal policy has no effect on the economy. The economy remains at point 1.
2. Tax cuts may either decrease or increase tax revenues. Do you agree or disagree?
Explain your answer.
Agree. Tax revenues may increase or decrease based on how much the tax base changes
when the average tax rate is changed.
Tax revenues = Tax base × (average) Tax rate
For example, a tax rate of 10 percent multiplied by a tax base of $100 billion generates $10
billion of tax revenues.
If the tax rate is reduced to 8 percent, the reduction is likely to increase the tax base to $110
billion. Tax revenues drop to $8.80 billion.
But, if the tax base expands to $130 billion, the tax revenues rise to $10.4 billion.
3. Give a numerical example to illustrate the difference between the marginal tax rate
and the average tax rate.
Taxable income Tax payment

$100 $10
$110 $12
Marginal tax rate = Δ Tax payment/Δ Taxable income

= $2/$10
= 20%
Average tax rate = Tax payment/Taxable income
= $10/$100
= 10%
4. Explain how, under certain conditions, expansionary fiscal policy can remove an
economy from a recessionary gap.
LRAS
SRAS
2
Price Level
AD2
AD1
0 Q1 QN Real GDP
In the above figure, the economy is in a recessionary gap at point 1. Assuming that there is no
crowding out or lags, an increase in government purchases and/or a decrease taxes will
increase aggregate demand. AD1 shifts to AD2. The economy moves out of the recessionary
gap and is in equilibrium at point 2.
5. Give a numerical example to illustrate the difference between a progressive and

proportional income tax structure.
Progressive Proportional
Taxable income
tax rate tax rate
0-$10,000 10% 10%
$10,001-$11,000 12% 10%
$11,001-$12,000 14% 10%
In a progressive income tax structure, the marginal tax rate increases as taxable income
increases. In a proportional income tax structure, the marginal tax rate is constant as taxable
income increases.
 ANSWERS TO CHAPTER QUESTIONS AND PROBLEMS

1. What is the difference between government expenditures and government
purchases?
198 Chapter 11
Government expenditures is the sum of government purchases and (government) transfer

payments. Government purchases do not include transfer payments.
2. How much were government expenditures in2013? How much were government
tax revenues in 2013?
Government expenditures equaled $3.685 trillion in 2013.

Government tax revenues equaled $2.712 trillion in 2013.
3. The bulk of federal government expenditures go for four programs. What are
they?
Social security, Medicare, Medicaid, and national defense account for the bulk of government
expenditures.
4. What percentage of total income did the top 10 percent of income earners earn
in2011? What percentage of federal income taxes did this group pay in 2011?
In 2011, the top 10 percent of income earners earned 45.4 percent of the total income earned
and paid 68.3 percent of the total federal income taxes collected.
5. Is it true that, under a proportional income tax structure, a person who earns a
high income will pay more in taxes than a person who earns a low income?
Explain your answer.
Yes, it is true. Under a proportional income tax structure, the absolute level of taxes someone
pays increases, but taxes as a proportion of income remain the same. For example, if the
income tax rate were 20 percent, someone earning $20,000 would pay $4,000 in taxes, and
someone earning $50,000 would pay $10,000 in taxes. The person earning $50,000 pays more
in taxes, but as a proportion of income, she pays the same amount as the person earning
$20,000.
6. A progressive income tax always raises more revenue than a proportional income
tax. Do you agree or disagree? Explain your answer.
Disagree. A progressive income tax can become burdensome on work effort and result in
smaller tax collections than a proportional tax. For example, a 100 percent tax on all income
above $100,000 would be highly progressive, and drive down work effort as well.
7. Jim favors progressive taxation and equal after-tax pay for equal work. Comment.
Progressive taxation is sometimes inconsistent with equal after-tax pay for equal work. To
illustrate, suppose each of two persons is paid $1,000 for doing the same job. If the two
individuals do not pay the same marginal tax rate, then one individual is left with less after-tax
pay for doing the same job the other person does. Simply put, sometimes you have to choose
between progressive taxation and equal after-tax pay for equal work.
8. What is the difference between a structural deficit and a cyclical deficit?
A cyclical deficit will disappear when the economy returns to full-employment, while a structural
deficit will not.
9. What is the difference between discretionary fiscal policy and automatic fiscal
policy?
When changes in government expenditures and taxes are brought about deliberately through
government actions, fiscal policy is said to be discretionary. In contrast, a change in either
government expenditures or taxes that occurs automatically in response to economic events is
referred to as automatic fiscal policy.
10. According to Buchanan and Wagner, why is there a political bias towards
expansionary fiscal policy and not contractionary fiscal policy?
Expansionary fiscal policy is likely to be more popular among the citizens than a
contractionary policy. If the political environment is such that the people do not want the
government to reduce spending benefits or raise taxes, then the government is less
likely to introduce these measures. Economic policies often have political dimensions
and politics often trumps economics.
11. Explain two ways crowding out may occur.
Crowding out may occur because individuals substitute government goods for private goods or
because financing the deficit pushes interest rates upward causing investment to fall.
12. Why is crowding out an important issue in the debate over the use of fiscal
policy?
Those who advocate the use of fiscal policy believe it is capable of affecting the aggregate
demand curve and therefore Real GDP. Crowding out calls the effectiveness of fiscal policy
into question. For example, if an increase in government purchases causes private
expenditures to fall by the same amount, then there is complete crowding out and th e
aggregate demand curve does not shift. Thus, there is no change in Real GDP.
13. Some economists argue for the use of fiscal policy to solve economic problems;
some argue against it. What are some of the arguments on both sides?
This answer is given with respect to demand-side fiscal policy only. Those in favor of the use of
fiscal policy often argue that the economy is not always self-regulating and that sometimes it
needs a push to move it in the right direction. Fiscal policy is that push. Those against the use of
fiscal policy often argue that the economy is self-regulating, that the existence of lags can turn a
potentially effective fiscal policy measure into the “wrong medicine at the wrong time,” and that
the existence of crowding out places a question mark over the effectiveness of fiscal policy.
14. Give a numerical example to illustrate the difference between complete crowding
out and incomplete crowding out.
Answers will vary. An example of complete crowding out would be if the government spends $1
million on food stamps and spending by food stamp recipients falls by $1 million. An example of
incomplete crowding out would be if the government spends $1 million on food stamps and
spending by food stamp recipients falls by $0.8 million.
200 Chapter 11
15. The debate over using government spending and taxing powers to stabilize the
economy involves more than technical economic issues. Do you agree or
disagree? Explain your answer.
Agree. Two technical issues that divide economists have to do with crowding out (Is there
crowding out or not?) and the existence and importance of lags (Are there lags? To what degree
do they diminish the effectiveness of fiscal policy? Are there ways to get around them?).
Besides disagreeing on technical points, economists may disagree as to the ethical decision to
run budget deficits, the long-run political consequences of permitting government to run
continuous annual deficits, and much more. Simply put, economic debates are not always
strictly limited to technical economic issues.
16. Is crowding out equally likely under all economic conditions? Explain your
answer.
No. The closer the economy is to its production possibilities frontier (i.e., full employment)
and/or the steeper the SRAS curve, the greater the likelihood of significant crowding out. The
condition of the financial market is also important. The tighter the supply of money and/or
loanable funds, the greater the likelihood of reduced private borrowing in the case of a budget
deficit.
17. Tax cuts will likely affect aggregate demand and aggregate supply. Does it matter
which is affected more? Explain in terms of the AD-AS framework.
Yes. If AD and SRAS both increase, real output will increase. However, the effect on the price
level depends upon the relative magnitudes of the changes in AD and SRAS. If AD increases by
more than SRAS, then the price level will rise. If SRAS increases by more than AD, then the
price level will fall., If AD and SRAS increase proportionally, then the price level should remain
constant.
18. Explain how, under expansionary fiscal policy, expansionary fiscal policy can, ,
destabilize the economy.
The government has to know a great deal to implement fiscal policy properly, including the true
state of the economy, and the values of Natural Real GDP and the MPC. If the government, for
example, were to misread the state of the economy as declining when in fact it were not, the
implementation of expansionary fiscal policy could turn equilibrium into an inflationary gap.
19. Identify and explain the five lags associated with fiscal policy.
The five types of lags include the data lag (policymakers are not aware of changes in the
economy as soon as they happen); the wait-and-see lag (policymakers rarely enact
counteractive measures immediately); the legislative lag (it can take months for policymakers to
propose a fiscal policy measure, build support for it, and get it passed); the transmission lag
(fiscal policy measures take time to be put into effect); and the effectiveness lag (after a policy
measure is implemented, it takes time to affect the economy).
20. Suppose the economy is in a recessionary gap, and both Smith and Jones
advocate expansionary fiscal policy. Does it follow that both Smith and Jones
favor so-called big government?
Not necessarily. Expansionary fiscal policy only results in permanently larger government if the
expenditure increases undertaken to shift the aggregate demand curve are left in place after the
need for the policy has passed. Also, Smith may prefer more government spending (bigger
government) while Jones prefers tax cuts (smaller government) when it comes to expansionary
fiscal policy.
21. Will tax cuts that the public perceives to be temporary affect the SRAS and LRAS
curves differently than tax cuts that are perceived to be permanent? Explain your
answer.
A temporary tax cut will not alter people’s work behavior because it is temporary and may not
impact SRAS, and should not impact LRAS at all. A permanent decrease in taxes should result
in a permanent change in the behavior of people toward greater work effort, resulting in
permanent rightward shifts of both the SRAS curve and the LRAS curve.
22. What is the difference between a marginal tax rate and an average tax rate?
A marginal tax rate is the rate paid on additional income while an average tax rate is the rate
paid on all income.
23 Will tax revenue necessarily rise if tax rates are lowered? Explain your answer.
No. The answer depends on how the change in the tax rate affects the tax base. If the tax rate
cut does not cause a large enough increase in the tax base, then tax revenue will fall.
24. Georgia Dickens is sitting with a friend at a coffee shop and they are talking about
the new tax bill. Georgia thinks that cutting tax rates at this time would be wrong:
“Lower tax rates,” she says, “will lead to a larger budget deficit, and the budget
deficit is already plenty big.” Do lower tax rates mean a larger deficit? Why or why
not?
Lower tax rates do not necessarily lead to a larger deficit. Lower tax rates could lead to higher
tax revenues which would lead to a smaller budget deficit. What matters is whether the
percentage cut in tax rates is larger or smaller than the percentage rise in the tax base.
 ANSWERS TO PROBLEMS IN THE WORKING WITH NUMBERS AND

GRAPHS SECTION
Use the following table to answer questions 1-4:
Taxable Income Taxes

$1,000-$5,000 10% of taxable income
$5,001-$10,000 $500 + 12% of everything over $5,000
$10,001-$15,000 $1,100 + 15% of everything over $10,000
1. If a person’s income is $6,000, how much does he pay in taxes?
He pays $500 plus 12% of $1,000 = $500 + $120 = $620.
202 Chapter 11
2. If a person’s income is $14,000, how much does she pay in taxes?
She pays $1,100 plus 15% of $4,000 = $1,100 + $600 = $1,700.
3. What is the marginal tax rate on the 10,001st dollar? What is the marginal tax rate
on the 10,000th dollar?
On the 10,000th dollar, taxes are $500 + 12% of $5,000 = $1,100

On the 10,001st dollar, taxes are $1,100 + 15% of $1 = $1,100.15
The marginal rate on the 10,001st dollar is 15%. The marginal rate on the 10,000th dollar is 12
percent.
4. What is the average tax rate of someone with a taxable income of $13,766?
The taxes paid are $1,100 + 15% of 3,766 = $1,664.90. That is an average tax rate of
$1,664.90/$13,766 = 12.09%.
5. A hypothetical society has three income earners, and all three must pay income
taxes. The taxable income of Smith is $40,000, the taxable income of Jones is
$100,000 and the taxable income of Brown is $200,000. (a) How much tax revenue
is raised under a proportional income tax where the tax rate is 10 percent? How
much is raised if the tax rate is 15 percent? (b) A progressive system is installed,
with a rate of 5 percent on an income of $0-$40,000, a rate of 8 percent on income
from $40,001 to $100,000, and a rate of 15 percent on all income over $100,000.
Will this system raise more or less tax revenue than a proportional tax rate of 10
percent? Explain your answer.
Total income is $340,000. (a) At a 10 percent flat rate, tax payments would be $34,000; at a 15
percent flat rate, tax payments would be $51,000. (b) With the progressive income tax system
specified, tax payments would be $40,000.
6. Show graphically show how fiscal policy works in the ideal case.
The two graphs that make up Exhibit 2 in the text explains this.
7. Illustrate graphically how government can use supply-side fiscal policy to get an
economy out of a recessionary gap.
SRAS1
LRAS1
Price
level
SRAS2
AD1
0 Q1 QN Real GDP
In the above figure, the economy is initially at Q1 in a recessionary gap. Government lowers
marginal tax rates, thus increasing the incentive to engage in productive activities (such as
work) and the SRAS curves shifts rightward from SRAS1 to SRAS2. At point 2, the economy is
long-run equilibrium.
8. Illustrate the following graphically:

(a) Fiscal policy destabilizes the economy.
(b) Fiscal policy eliminates an inflationary gap.
(c) Fiscal policy only partly eliminates a recessionary gap.
204 Chapter 11
(a) The economy is at Q1 in a recessionary gap and government increases AD too much,
resulting in an inflationary gap at Q2.
(b) The government shifts AD from AD1 to AD2, which moves the economy to QN.
(c) The government shifts AD from AD1 to AD2, which fails to move the economy completely to
Q N.

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B. Government Tax Revenues

C. Social Security, Medicare, and Medicaid in the Future

In the year 2050, if tax revenues as a percentage of GDP are expected to be 19

1. Income Tax Structures

An income tax structure can be progressive (the tax rate increases as a

2. Who Pays the Income Tax?

E. Budget Deficit, Surplus, or Balance

F. An Interesting Fact: Taxing Millionaires and the Budget Deficit

G. Structural and Cyclical Deficits

H. The Public Debt

There are two things to understand about a value-added tax.

1. The Value-Added Part - Value added is the difference between what a

J. Tax Deductions vs Subsidies

II. FISCAL POLICY

A. Some Relevant Fiscal Policy Terms

Expansionary fiscal policy refers to increases in government expenditures and/or

B. Two Important Notes

III. DEMAND-SIDE FISCAL POLICY

A. Shifting the Aggregate Demand Curve

An increase in government purchases (G) increases aggregate demand (AD)

A change in taxes can affect consumption or investment or both and therefore

B. Fiscal Policy: Keynesian Perspective (Economy Is Not Self-Regulating)

The Keynesian prescription for a recessionary gap is to enact expansionary fiscal

C. Crowding Out: Questioning Expansionary Fiscal Policy

D. Lags and Fiscal Policy

There are five types of lags:

2. The Wait-and-See Lag—the time between when policymakers notice a

3. The Legislative Lag—the time it takes to get a policy action approved.

4. The Transmission Lag—the time required to put a policy into effect.

5. The Effectiveness Lag—the time the economy takes to respond once a

E. Crowding Out, Lags, and the Effectiveness of Fiscal Policy

In their book Democracy in Deficit, economists James Buchanan and Richard

IV. SUPPLY-SIDE FISCAL POLICY

A. Marginal Tax Rates and Aggregate Supply

B. The Laffer Curve: Tax Rates and Tax Revenues

Tax revenues = Tax base x (average) Tax rate

C. Fiscal Policy and Expectations

 ASSIGNMENTS FOR MASTERING KEY IDEAS

1. Define the following terms:

 ANSWERS TO ASSIGNMENTS FOR MASTERING KEY IDEAS

Assignment 11.2 Answers

Assignment 11.3 Answers

Assignment 11.4 Answers

Assignment 11.5 Answers

Assignment 11.6 Answers

Assignment 11.7 Answers

Assignment 11.8 Answers

Assignment 11.9 Answers

Assignment 11.10 Answers

 ANSWERS TO VIDEO QUESTIONS AND PROBLEMS

Tax revenues = Tax base × (average) Tax rate

Taxable income Tax payment

Marginal tax rate = Δ Tax payment/Δ Taxable income

5. Give a numerical example to illustrate the difference between a progressive and

0-$10,000 10% 10%

$10,001-$11,000 12% 10%

$11,001-$12,000 14% 10%

 ANSWERS TO CHAPTER QUESTIONS AND PROBLEMS

Government expenditures is the sum of government purchases and (government) transfer

Government expenditures equaled $3.685 trillion in 2013.

8. What is the difference between a structural deficit and a cyclical deficit?

11. Explain two ways crowding out may occur.