Chapter 6:

Fiscal Policy, taxes, budgets

Government Expenditures
 Budget Deficit, Surplus, or Balance

• Budget Deficit
- Government expenditures greater than tax revenues.

• Budget Surplus
- Tax revenues greater than government expenditures.

• Balanced Budget
- Government expenditures equal to tax revenues.
Government Tax Revenues
Major Government Taxes

• Personal Income Tax:

- paid on a person’s taxable income.
- Taxable income is income minus any exemptions and deductions.

• Corporate Income Tax:

- paid on a corporation’s profits

• Social Security Tax:

- paid from a person’s income and from an employer.
Three Personal Income Tax Structures
1. Progressive Income Tax:
- the tax rate increases as a person’s taxable
income level rises.
- A progressive tax is usually capped at some tax rate.
2. Regressive Income Tax:
- the tax rate decreases as a person’s taxable income level rises.
3. Proportionate Income Tax:
- the same tax rate is used for all levels. This is sometimes called a
flat tax.
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.

• Government expenditures is the sum of government purchases and

transfer payments.

• Expansionary fiscal policy refers to increases in government expenditures

and/or decreases in taxes to achieve macroeconomic goals.

• Contractionary fiscal policy attempts to decrease government

expenditures and/or increases in taxes to achieve macroeconomic goals.

• Discretionary Fiscal Policy is deliberate changes of government

expenditures and/or taxes to achieve particular economic goals.

• Automatic Fiscal Policy is changes in government expenditures and/or

taxes that occur automatically without (additional) congressional action.
Two Key Assumptions

• In our discussion of fiscal policy, we only deal with discretionary fiscal

policy.

• We assume that any change in government spending is due to a

change in government purchases and not to a change in transfer
payments.
Demand-Side Fiscal Policy

• A change in consumption, investment, government purchases, or

net exports can change aggregate demand and therefore shift
the AD curve.

• A change in taxes can affect consumption or investment or both

and there for can affect aggregate demand.
Fiscal Policy: A Keynesian Perspective
Crowding Out

• Refers to a decrease in private expenditures (household and

business expenditures) that occurs as a consequence of
increased government spending or the financing needs of a
budget deficit.

• Economists who believe the crowding out phenomenon

exists argue that because of the direct substitution of public
services for consumer spending or because of higher interest
rates, increases in government spending induce consumers
and investors to spend less.
Types of Crowding Out:
1. Complete Crowding Out → occurs when the decrease in one or
more components of private spending completely offsets the
increase in government spending.

2. Incomplete Crowding Out → occurs when the decrease in one or

more components of private spending only partially offsets the
increase in government spending.

→ If complete or incomplete crowding out occurs, it follows that

expansionary fiscal policy will have less impact on aggregate demand and
Real GDP than Keynesian theory predicts.
• In Keynesian theory,
expansionary fiscal policy shifts
the aggregate demand curve to Keynesian Theory & Crowding Out
AD2 and moves the economy to
point 2.

• If there is no crowding out,

expansionary fiscal policy
increases Real GDP and lowers
the unemployment rate.

• If there is incomplete crowding

out, expansionary fiscal policy
increases Real GDP and lowers
the unemployment rate, but
not as much as in the case of
zero crowding out.

• If there is complete crowding

out, expansionary fiscal policy
has no effect on the economy.
 Demand-Side Fiscal Policy: Return to the Keynesian Model

→ It would seem that under the

conditions of no lags and zero
crowding out, expansionary fiscal
policy – either increasing
government spending or cutting
taxes – will work at removing the
economy from a recessionary gap.
 Demand-Side Fiscal Policy: Return to the Keynesian Model

→ If government knows
the difference between Q1
and QN (so that it knows
how much to change Real
GDP) and it knows the MPC,
then it can use fiscal policy
to get the economy out of a
recessionary gap and
producing Natural Real GDP.
 Demand-Side Fiscal Policy: Return to the Keynesian Model

• If the government doesn’t

know the actual MPC and it
doesn’t know the actual
difference between Q1 and
QN, then fiscal policy isn’t
likely to work as intended.
 Tax Cuts Instead: Are Things Any Different?

• An important equation:

Real GDP = -MPC(m) x T

• A dollar spend by government is a dollar spent; a dollar tax cut is a

dollar partly saved and partly spent.

• In order to get the same change in Real GDP, government has to cut
taxes more than it has to raise purchases.
SELF-TEST

1. How does crowding out question the effectiveness of

expansionary demand-side fiscal policy?

2. Do budget deficits raise interest rates?

3. How can an increase in the size of the federal budget

deficit affect the trade deficit?
 Supply-Side Fiscal Policy
• All other things held constant, lower marginal tax rates increase the incentive
to engage in productive activities relative to leisure and tax avoidance
activities.

• Marginal Tax Rate = (Δ Tax payment)/(Δ Taxable Income)

• Given a cut in marginal tax rates two things will happen:

1. Individuals will have more disposable income;
2. the amount of money they can earn by working increases.

• In the analysis of marginal tax rates and aggregate supply, we implicitly assume
that in the aggregate, a marginal tax rate cut increases work activity.
The Predicted Effect of a Permanent Marginal Tax Rate Cut on AS
The Laffer Curve: Tax Rates and Tax Returns
• If income tax rates were lowered, would it increase or
decrease tax revenue?

• There are two tax rates at which zero tax revenues will be
collected – 0 and 100%.

• An increase in tax rates could cause tax revenues to increase.

• A decrease in tax rates could cause tax revenues to increase.

• Tax revenues = (Tax base) x (the average Tax rate)

The Laffer Curve: Tax Rates and Tax Returns
 The Laffer Curve: Implications
• We assume that as the tax rate is reduced, the tax base
expands.

• The rationale is that individuals work more, invest more, and

enter into more exchanges, and shelter less income from taxes
and lower tax rates.

• How much does the tax base expand following the tax rate
reduction?

• Tax revenues increase if a tax reduction is made in the

downward-sloping portion of the curve (between points B and
C); tax revenues decrease following a tax rate reduction in the
upward sloping portion of the curve (between points A and B).
SLEF-TEST

1. Give an arithmetical example to illustrate the difference

between the marginal and average tax rates.

2. If income tax rates rise, will income tax revenue rise as well?