Macroeconomics

Module 11: Fiscal Policy

Fiscal Policy and the Federal Budget
Fiscal Policy: changes in Federal government spending or tax rates for
the purpose of influencing the macroeconomy
Fiscal policy is one of two policy tools for managing the economy (monetary
policy is the other)
Fiscal policy is decided by PM and the President
The discussion of fiscal policy focuses on how federal government taxing and
spending affects aggregate demand
Government Spending
Balanced Budget: when government spending and taxes are equal

Budget Deficit: when the federal government spends more money than
it receives in taxes in a given year

Budget Surplus: when the government receives more money in taxes

than it spends in a year
Total U.S. Government Spending

Government spending covers a range of services provided by the federal,

state, and local governments
Federal spending in nominal dollars (that is, dollars not adjusted for
inflation) has grown by a multiple of more than 38 over the last four decades
State and Local Government Spending

 Spending by state and local government increased from about 10% of GDP in the early 1960s to
14–16% by the mid-1970s. It has remained at roughly that level since. The single biggest spending
item is education, including both K–12 spending and support for public colleges and universities,
which has been about 4–5% of GDP in recent decades. Source: (Source: Bureau of Economic
Analysis.)
Taxation
Ability to Pay Principle: normative argument that citizens with more
income or wealth should bear more of the cost of social programs by
paying a higher tax rate, since they have a greater ability to pay
Benefit Principle: normative argument that tax payers should pay in
proportion to the benefit they receive
Corporate Income Tax: a tax imposed on corporate profits
Estate and Gift Tax: a tax on people who pass assets to the next
generation—either after death or during life in the form of gifts
Excise Tax: a tax on a specific good—on gasoline, tobacco, and alcohol
Flat Tax: proportional income tax system where all individuals pay the
same income tax rate
Individual Income Tax: a tax based on the income, of all forms,
received by individuals
Taxation (cont.)
Marginal Tax Rates: the tax one pays on the higher income one earns;
Payroll Tax: a tax based on the pay received from employers; the taxes
provide funds for Social Security and Medicare
Progressive Tax: a tax that collects a greater share of income from
those with high incomes than from those with lower incomes
Property Taxes: taxes based on the value of your home or other real
estate
Proportional Tax: a tax that is flat percentage of income earned,
regardless of level of income
Regressive tax: people with higher incomes pay a smaller share of
their income in tax
Sales Tax: taxes as a percentage of one’s retail purchases
Federal Taxes Federal tax revenues have
been about 17–20% of GDP
during most periods in
recent decades. The
primary sources of federal
taxes are individual income
taxes and the payroll taxes
that finance Social Security
and Medicare. Corporate
income taxes and social
insurance taxes provide
smaller shares of revenue.
Progressive, Proportional, and Regressive Taxes
Taxes can be categorized as progressive, proportional or regressive based on
how their marginal tax rate changes as income goes up.

 A tax is progressive if you pay a higher marginal tax rate as your income rises.

 A tax is proportional if your tax rate doesn’t change as your income rises; i.e.
you pay the same rate at every income level.

 A tax is regressive if you pay a lower marginal tax rate as your income rises.
State and Local Taxes
The main revenue sources for state and local governments are sales taxes,
property taxes, and revenue passed along from the federal government

Many state and local governments also levy personal and corporate
income taxes, as well as impose a wide variety of fees and charges

Some states rely more on property taxes, some on sales taxes, some on
income taxes, and some more on revenues from the federal government
Federal Budgets and National Debt
National Debt: the total
accumulated amount the
government has
borrowed, over time, and
not yet paid back
The federal government
has run budget deficits
for decades
Debt/GDP

Ratio
Federal debt is the sum of
annual budget deficits and
surpluses. Annual deficits do not
always mean that the debt/GDP
ratio is rising.
During the 1960s and 1970s, the
government often ran small
deficits, but since the debt was
growing more slowly than the
economy, the debt/GDP ratio
was declining over this time. In
the 2008–2009 recession, the
debt/GDP ratio rose sharply
The Question of a Balanced Budget
Most economists view the proposals for a
perpetually balanced budget with bemusement
Economists would expect the budget deficits
and surpluses to fluctuate up and down with
the economy and the automatic stabilizers
Some supporters of the balanced budget
amendment like to argue that, since
households must balance their own budgets,
the government should too
There is also no particular reason to expect a
government budget to be balanced in the
medium term of a few years
Automatic Stabilizers
Automatic Stabilizers: tax and spending rules that have the effect of
slowing down the rate of decrease in aggregate demand when the
economy slows down and restraining aggregate demand when the
economy speeds up, without any additional change in legislation
Discretionary Fiscal Policy: the government passes a new law that
explicitly changes overall tax rates or spending levels with the intent of
influencing the level or overall economic activity
Standardized (or full) Employment Budget: estimate of the budget
deficit or surplus excluding the effects of fiscal policy, that is, as if GDP
were at potential
Automatic Stabilizers (cont.)
Automatic stabilizers include
unemployment insurance, food
stamps, and the personal and
corporate income tax
Automatic stabilizers, like welfare
programs such as food stamps,
automatically kick in when
aggregate demand falls.
Expansionary and Contractionary Fiscal Policy
Contractionary Fiscal Policy: fiscal policy that decreases the level of
aggregate demand, either through cuts in government spending or
increases in taxes
Expansionary Fiscal Policy: fiscal policy that increases the level of
aggregate demand, either through increases in government spending or
cuts in taxes
Expansionary Fiscal Policy
Expansionary fiscal policies include:
1. increasing consumption by raising disposable income through cuts in
personal income taxes or payroll taxes;
2. increasing investments by raising after-tax profits through cuts in business
taxes; and
3. increasing government purchases through increased spending by the
federal government on final goods and services and raising federal grants
to state and local governments to increase their expenditures on final
goods and services.
Contractionary Fiscal Policy
Fiscal policy can also be
used to slow down an
overheating economy
Again, the AD–AS
model does not dictate
how this contractionary
fiscal policy is to be
carried out
Neoclassical Fiscal Policy and Supply-Side
Economics
Austerity Programs: measures taken to reduce budget deficits during
recessions by raising taxes and cutting government spending
Crowding Out: federal spending and borrowing causes interest rates to rise and
business investment to fall; crowding out can also be caused by federal tax cuts
Flat Tax Income Tax: system where all pay the same tax rate
Laffer Curve: hill-shaped relationship between tax rates and tax revenues; if tax
rates are high enough, lowering rates actually increases revenues
Multiplier Effect: idea that a change in spending causes a more than
proportionate change in real GDP
Reaganomics: see Supply-Side Economics
Supply-Side Economics: belief that economic activity is motivated by after tax
returns to that activity, so that tax cuts on personal income increase labor
supply, tax cuts on saving increase saving, and tax cuts on investment increase
Supply-Side Economics
Supply-siders argue that three key elements affect the macro economy:
Labor supply, which is determined by wages and salaries after taxes are
removed (e.g. take-home pay);
Saving, which is determined by the after-tax rate of return to saving; and
Business investment, which is determined by the after-tax rate of return to
capital investment.
A flat tax is proportional, meaning that all individuals or corporations
would pay the same tax rate
The Laffer Curve is somewhat controversial in practice
Fiscal Policy, Investment, and Crowding Out
Head Start Program: a program for early childhood education directed
at families with limited educational and financial resources

Infrastructure: public investment in public and externality goods like

roads and transportation features (e.g. airports, seaports), water supply
and sewers, schools and hospitals.
Crowding Out Physical Capital Investment
When government conducts an expansionary fiscal policy, it may run
afoul of the crowding out effect

Expansionary fiscal policy means an increase in the budget deficit

When government borrowing soaks up available financial capital and

leaves less for private investment in physical capital
Public Investment in Physical and Human Capital, and
Technology
All government spending does not cause crowding out
Public infrastructure spending on physical capital can enhance private
investment
In most countries, the government plays a large role in society’s
investment in human capital through the education system
Not all spending on educational human capital needs to happen through
the government
Research and development (R&D) efforts are the lifeblood of new
technology
Fiscal policy can encourage R&D using either direct spending or tax policy
Quick

Review
What are some examples of fiscal policy?
Describe the federal budget and identify deficit and surplus trends over the
past five decades
Describe state and local government spending, including main expenses
What are the major sources of revenue for the U.S. federal budget as well as
state and local governments?
What is the difference between regressive tax, a proportional tax, and a
progressive tax?
What is the difference between deficit and debt?
Explain how economic growth or decline can influence a budget surplus or
budget deficit.
Describe the arguments for and against requiring the U.S. federal budget to
be balanced.
More Quick Review
Describe how fiscal policy can be designed to stabilize the economy using
automatic stabilizers.
Explain how expansionary fiscal policy can increase aggregate demand and
boost the economy.
Explain how contractionary fiscal policy can decrease aggregate demand
and depress the economy.
Explain supply-side economics, including the role of tax cuts and the
Laffer curve.
Compare and contrast Keynesian and neoclassical approaches to fiscal
policy.
What is crowding out and its effect on physical capital investment?
How is economic growth tied to investments in physical capital, human
capital, and technology?