FISCAL POLICY AND

THE FEDERAL BUDGET

THE FEDERAL BUDGET
THE FEDERAL BUDGET
 The Federal Budget is composed of two, not necessarily
equal, parts: Government Expenditures and Tax
Revenues.

 Note: Government Expenditure is NOT the same

Government Purchases. Government Expenditures
include Government Purchases and Transfer Payments.

 Government Tax Revenues: Includes all taxes that are

collected by the government, direct, indirect, social
security taxes.
SOME NUMBERS FROM THE
BANGLADESH ECONOMY..

Tax Revenues (% Cash Surplus/Deficit GDP Growth

Year of GDP) (% of GDP) Rate (%)
2001 7.60 -0.66 5.27
2002 7.70 -0.17 4.42
2003 8.07 -0.12 5.26
2004 8.11 -0.73 6.27
2005 8.22 -1.12 5.96
2006 8.17 -1.44 6.63
2007 8.05 -1.33 6.43
2008 8.82 -0.96 6.19
2009 8.60 -1.66 5.74
2010 9.00 -0.93 6.07
2011 9.98 -0.93 6.71
INCOME TAX STRUCTURES
 Income Tax is usually a large portion of the government
tax revenue.

 Progressive Tax: An income tax system in which one’s

tax rate rises as one’s taxable income rises. A progressive
income tax is usually capped at some rate.
 Proportional Tax: An income tax system in which a
person’s tax rate is the same no matter what his or her
taxable income is. It is sometimes referred to as flat tax.
 Regressive Income Tax: An income tax system in which
a person’s tax rate declines as his or her taxable income
rises.
BUDGET DEFICIT, SURPLUS OR
BALANCE
 If expenditures are greater than tax revenues, a budget
deficit exists.
 If tax revenues are greater than expenditures, a budget
surplus exists
 If expenditures equals tax revenues, a balanced budget
exists.

 In case of a budget deficit, how is the government

financing the additional expenditure?
STRUCTURAL AND CYCLICAL DEFICITS
 Cyclical Deficit: The part of the budget deficit that is a
result of a downturn in economic activity.

 Structural Deficit: The part of the budget deficit that

would exist even if the economy were operating at full
employment.

 Total Budget Deficit = Structural Deficit + Cyclical

Deficit
THE PUBLIC DEBT
 A budget deficit occurs when government expenditures
are greater than tax revenues for a single year.

 Public Debt (National debt) is the TOTAL amount the

federal government owes its creditors.

 Some of this is held by one entity in the government or

owes it to another.
 The remainder is held by the public (net public debt)
FISCAL POLICY
FISCAL POLICY
 Fiscal Policy: Changes in government expenditures and/or
taxes to achieve economic goals, such as low
unemployment, stable prices and economic growth.
 Expansionary Fiscal Policy: Increase in government
expenditure and/or decreases in taxes to achieve particular
economic goals.
 Contractionary Fiscal Policy: Decrease in government
expenditure and/or increases in taxes to achieve particular
economic goals.
 Discretionary Fiscal Policy: Deliberate changes of
government expenditures and/or taxes to achieve economic
goals.
 Automatic Fiscal Policy: Changes in government
expenditures and/or taxes that occur automatically without
additional government action.
DEMAND-SIDE FISCAL POLICY
 Fiscal Policy affect the demand side by shifting the AD
curve.

 Government Purchases: Increase shifts the AD to the right,

decreases shifts the AD to the left.

 Taxes can affect consumption and/or investment, can will

lead to shifts in AD
 Decrease in Income Tax  Rises Disposable Income 
Raises Consumption  Shifts AD to right
 Decrease in Business Tax  Rises After tax profit
Raises Investment  Shifts AD to right
FISCAL POLICY: KEYNESIAN PERSPECTIVE
(ECONOMY IS NOT SELF-REGULATING)
RECESSIONARY GAP
 Keynesians believe that
economy is not self-
regulating.
 The Keynesian prescription
is to enact expansionary
fiscal policy (Increase G
and/or Reduce T) to shift
AD to the right.
 Move from Point 1 to Point
2.
FISCAL POLICY: KEYNESIAN
PERSPECTIVE (ECONOMY IS NOT SELF-
REGULATING)
INFLATIONARY GAP
 Keynesians believe that
economy is not self-
regulating.
 The Keynesian
prescription is to enact
contractionary fiscal
policy (Decrease G
and/or Increase T) to
shift AD to the left.
 Move from Point 1 to
Point 2.
CROWDING OUT: QUESTIONING
EXPANSIONARY 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.

 Economists who believe the crowding out phenomenon

exists argue that because of the direct substitution of
public services for consumer spending [DIRECT
EFFECT] or because of higher interest rates, increases in
government spending induce consumers and investors to
spend less [INDIRECT EFFECT].
TYPES OF CROWDING OUT
 Complete Crowding Out occurs when the decrease in
one or more components of private spending completely
offsets the increase in government spending.
 Incomplete Crowding Out occurs when the decrease in
one or more components of private spending only
partially offsets the increase in government spending.
 Whether we are dealing with complete or incomplete
crowding out, the crowding out effect suggests that
expansionary fiscal policy will have less impact on
aggregate demand and Real GDP than Keynesian
theory predicts.
GRAPHICAL REPRESENTATION
OF CROWDING OUT
 In Keynesian theory, expansionary
fiscal policy shifts the aggregate
demand curve to 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.
LAGS AND FISCAL POLICY
1. The Data Lag
2. The Wait-And-See Lag
3. The Legislative Lag
4. The Transmission Lag
5. The Effectiveness Lag

Some economists argue that discretionary fiscal policy is

not likely to have the impact on the economy that
policymakers hope. 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 it may have changed altogether.
LAGS AND FISCAL POLICY
The government has
moved the economy
from point 1 to point
2, and not, as they
had hoped, from
point 1 to point 1’.
CROWDING OUT, LAGS, AND THE
EFFECTIVENESS OF FISCAL POLICY
 Economists who believe that there is zero crowing out
and/or that lags are insignificant conclude that fiscal
policy is effective in moving economy out of
recessionary gap.

 Economists who believe that there is complete crowing

out and/or that lags are significant conclude that fiscal
policy is ineffective in moving economy out of
recessionary gap.
SUPPLY SIDE FISCAL POLICY
MARGINAL TAX RATES AND
AGGREGATE SUPPLY
  
 All other things held constant, lower marginal tax rates
increase the incentive to engage in productive activities
relative to leisure and tax avoidance activities.  SRAS
shifts right.
 If lower rates are permanent  LRAS will shift.
 Given a cut in marginal tax rates two things will happen:
Individuals will have more disposable income; 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 AGGREGATE SUPPLY
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.
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 = Tax Base X (average Tax rate)

 Numerically…
THE LAFFER CURVE: IMPLICATIONS
 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).