CHAPTER 30

Fiscal Policy
After studying this chapter you will be able to

Describe the federal budget process and the recent

history of outlays, tax revenues, deficits, and debts
Explain the The Supply-Side: Employment and Potential
GDP on employment and potential GDP
Explain the effects of deficits on investment, saving, and
economic growth
Explain how fiscal policy choices redistribute benefits and
costs across generations
Explain how fiscal policy can be used to stabilize the
business cycle
Balancing Acts on Capitol Hill

In 2007, the federal government planned to spend 21.1

cents out of each dollar earned in the United States and
collected 18.2 cents per dollar in taxes.
How does the government’s planned deficit affect the
economy?
Federal government deficits are not new. Apart from four
years 19982001, the federal government has had a
budget deficit.
How do government deficits and the debt they bring affect
the economy?
The Federal Budget

The federal budget is the annual statement of the federal

government’s outlays and tax revenues.
The federal budget has two purposes:
1. To finance the activities of the federal government
2. To achieve macroeconomic objectives
Fiscal policy is the use of the federal budget to achieve
macroeconomic objectives, such as full employment,
sustained economic growth, and price level stability.
The Federal Budget

The Institutions and

Laws
The President and
Congress make fiscal
policy.
Figure 30.1 shows the
timeline for the 2007
budget.
The Federal Budget

Employment Act of 1946

Fiscal policy operates within the framework of the
Employment Act of 1946 in which Congress declared
that
. . . it is the continuing policy and responsibility of
the Federal Government to use all practicable means
. . . to coordinate and utilize all its plans, functions,
and resources . . . to promote maximum employment,
production, and purchasing power.
The Federal Budget

The Council of Economic Advisers

The Council of Economic Advisers monitors the
economy and keeps the President and the public well
informed about the current state of the economy and the
best available forecasts of where it is heading.
This economic intelligence activity is one source of data
that informs the budget-making process.
The Federal Budget

Highlights of the 2007 Budget

The projected fiscal 2007 Federal Budget has revenues of
$2,521 billion, outlays of $2,891 billion, and a projected
deficit of $370 billion.
Revenues come from personal income taxes, social
security taxes, corporate income taxes, and indirect taxes.
Personal income taxes are the largest revenue source.
Outlays are transfer payments, expenditure on goods and
services, and debt interest.
Transfer payments are the largest item of outlays.
The Federal Budget

Surplus or Deficit
The federal government’s budget balance equals tax
revenue minus outlays.
If revenues exceed outlays, the government has a budget
surplus.
If outlays exceed revenues, the government has a budget
deficit.
If revenues equal outlays, the government has a balanced
budget.
The projected budget deficit in fiscal 2007 is $370 billion.
The Federal Budget

The Budget in Historical Perspective

Figure 30.1 on the next slide shows the government’s tax
revenues, outlays, and budget surplus or deficit as a
percentage of GDP for the period 1980 to 2006.
The government deficit peaked at 5.2 percent of GDP in
1983.
The deficit declined through 1989 but climbed again during
the 1990–1991 recession and then began to shrink.
In 1998, a surplus emerged.
But by 2002, the budget was again in deficit.
The Federal Budget
The Federal Budget

Revenues
Figure 30.2 shows revenues as a percentage of GDP.
The Federal Budget
Outlays
Figure 30.3 shows outlays as a percentage of GDP.
The Federal Budget

Budget Balance and

Debt
Government debt is the
total amount that the
government has borrowed.
It is the sum of past
deficits minus past
surpluses.
Figure 30.4 shows the
federal government’s
gross debt
… and net debt.
The Federal Budget

The U.S. Government

Budget in Global
Perspective
Figure 30.5 compares
government budget deficits
around the world in 2006.
Governments in most
countries had budget
deficits in 2006.
A few governments have
budget surpluses.
The Federal Budget

State and Local Budgets

The total government sector includes state and local
governments as well as the federal government.
In 2005, when federal government outlays were about
$2,500 billion, state and local outlays were almost $1,700
billion.
Most of state expenditures were on public schools,
colleges, and universities ($550 billion); local police and
fire services; and roads.
The Supply-Side: Employment and
Potential GDP

Fiscal policy has important effects on employment,

potential GDP, and aggregate supply. This is called
supply-side effects.
An income tax changes full employment and potential
GDP.
The Supply-Side: Employment and
Potential GDP
Full Employment and
Potential GDP
Figure 30.6(a) illustrates
the effects of an income
tax in the labour market.
The supply of labour
decreases because the
tax decreases the after-
tax wage rate.
The Supply-Side: Employment and
Potential GDP

The before-tax real wage

rate rises but the after-tax
real wage rate falls.
The quantity of labour
employed decreases.
The gap created between
the before-tax and after-
tax wage rates is called
the tax wedge.
The Supply-Side: Employment and
Potential GDP

When the quantity of

labour employed
decreases,
... potential GDP
decreases.
The supply-side effect of a
rise in the income tax
decreases potential GDP
and decreases aggregate
supply.
The Supply-Side: Employment and
Potential GDP
Taxes on Expenditure and the Tax Wedge
Taxes on consumption expenditure add to the tax wedge.

Figure 30.7 shows

some real-world
tax wedges.
The U.S. tax
wedge is relatively
small.
The Supply-Side: Employment and
Potential GDP

Tax Revenues and the

Laffer Curve
The relationship between
the tax rate and the
amount of tax revenue
collected is called the
Laffer curve.
For a tax rate below T* a
rise in the tax rate
increases tax revenue.
The Supply-Side: Investment, Saving,
and Economic Growth
Sources of Investment Finance
GDP = C + I + G + (X – M)
And
GDP = C + S + T
So I + G + (X – M) = S + T
I = S + (T – G) + (M – X)
Private saving PS = S + (M – X)
So I = PS + (T – G)
The Supply-Side: Investment, Saving,
and Economic Growth
I = PS + (T – G)
 If T exceeds G, the government sector has a budget
surplus and government saving (T – G) is positive.
 If G exceeds T, the government sector has a budget
deficit and government saving (T – G) is negative.
Figure 30.9 on the next slide shows the sources of
investment finance in the United States.
The Supply-Side: Investment, Saving,
and Economic Growth
The Supply-Side: Investment, Saving,
and Economic Growth
Fiscal policy influences investment and saving in two
ways:
 Taxes affect the incentive to save and change the
supply of loanable funds.
 Government saving is a component of total saving and
the supply of loanable funds.
The Supply-Side: Employment and
Potential GDP
Taxes and the Incentive to
Save
Figure 30.10 illustrates the
effects of a tax on capital
income.
A tax decreases the supply
of loanable funds, and
a tax wedge is driven
between the interest rate and
the after-tax interest rate.
Investment and saving
decrease.
The Supply-Side: Employment and
Potential GDP
Government Saving
Figure 30.11 illustrates a
crowding-out effect of a
budget deficit.
With a balanced budget,
the supply of loanable
funds is the private supply
PSLF.
A budget deficit decreases
the supply of loanable
funds …
The Supply-Side: Employment and
Potential GDP
The supply of loanable
funds is SLF.
The interest rate rises and
investment decreases.
The higher interest rate
increases private saving.
The tendency for the
budget deficit to decrease
investment is called the
crowding-out effect.
The Supply-Side: Employment and
Potential GDP

In the crowding-out case, the quantity of private saving

changes along the PSLF curve as the real interest rate
rises.
But suppose that the budget deficit (government
borrowing) changes private saving and shifts the PSLF
curve. This possibility is called the Ricardo-Barro effect.
Ricardo-Barro equivalence is the proposition that taxes
and government borrowing are equivalent—budget deficit
has no effect on the real interest rate or investment.
Generational Effects of Fiscal Policy
Is the budget deficit a burden of future generations?
Is the budget deficit the only burden of future generations?
What about the deficit in the Social Security fund?
Does it matter who owns the bonds that the government
sells to finance its deficit?
To answer questions like these, we use a tool called
generation accounting.
Generational accounting is an accounting system that
measures the lifetime tax burden and benefits of each
generation.
Generational Effects of Fiscal Policy
Generational Accounting and Present Value
Taxes are paid by people with jobs. Social security benefits
are paid to people after they retire.
So to compare the value of an amount of money at one date
(working years) with that at a later date (retirement years),
we use the concept of present value.
A present value is an amount of money that, if invested
today, will grow to equal a given future amount when the
interest that it earns is taken into account.
If the interest rate is 5 percent a year, $1,000 invested in
2006 will grow, with interest, to $11,467 after 50 years.
The present value (in 2006) of $11,467 in 2056 is $1,000.
Generational Effects of Fiscal Policy
The Social Security Time Bomb
Using generational accounting and present values,
economists have found that the federal government is
facing a Social Security time bomb!
In 2008, the first of the baby boomers will start collecting
Social Security pensions and in 2011, they will become
eligible for Medicare benefits.
By 2030, all the baby boomers will have retired and,
compared to 2006, the population supported by Social
Security will have doubled.
Generational Effects of Fiscal Policy
Under the existing Social Security laws, the federal
government has an obligation to pay pensions and
Medicare benefits on an already declared scale.
To assess the full extent of the government’s obligations,
economists use the concept of fiscal imbalance.
Fiscal imbalance is the present value of the government’s
commitments to pay benefits minus the present value of its
tax revenues.
Gokhale and Smetters estimated that the fiscal imbalance
was $45 trillion in 2003—4 times the value of total
production in 2003 ($11 trillion).
Generational Effects of Fiscal Policy
Generational Imbalance

Generational imbalance
is the division of the fiscal
imbalance between the
current and future
generations, assuming that
the current generation will
enjoy the existing levels of
taxes and benefits.
The bars show the scale of
the fiscal imbalance.
Generational Effects of Fiscal Policy
International Debt
How much investment have we paid for by borrowing from
the rest of the world? And how much U.S. government debt
is held abroad?
In June 2006, the United States had a net debt to the rest
of the world of $5.2 trillion.
Of that debt, $2.2 trillion was U.S. government debt.
Total U.S. government debt is $4.1 trillion.
So more than half of the outstanding government debt is
held by foreigners.
Stabilizing the Business Cycle

Fiscal policy actions that seek to stabilize the business cycle

work by changing aggregate demand.
■ Discretionary or
■ Automatic
Discretionary fiscal policy is a policy action that is initiated by
an act of Congress (USA) / National Assembly (in case of
Pakistan) e.g. Change in spending program or change in tax
rate is a discretionary fiscal policy.
Automatic fiscal policy is a change in fiscal policy triggered by
the state of the economy.
Stabilizing the Business Cycle

The Government Expenditure Multiplier

The government expenditure multiplier is the
magnification effect of a change in government
expenditure on goods and services on aggregate demand.
A multiplier exists because government expenditure is a
component of aggregate expenditure.
An increase in government expenditure increases income,
which induces additional consumption expenditure and
which in turn increases aggregate demand.
Stabilizing the Business Cycle

The Autonomous Tax Multiplier

The autonomous tax multiplier is the magnification effect
of a change in autonomous taxes on aggregate demand.
A decrease in autonomous taxes increases disposable
income, which increases consumption expenditure and
increases aggregate demand.
The magnitude of the autonomous tax multiplier is smaller
than the government expenditure multiplier because a $1
tax cut induces less than a $1 increase in consumption
expenditure.
Stabilizing the Business Cycle

The Balanced Budget Multiplier

The balanced tax multiplier is the magnification effect on
aggregate demand of a simultaneous change in
government expenditure and taxes that leaves the budget
balance unchanged.
The balanced budget multiplier is positive because a $1
increase in government expenditure increases aggregate
demand by more than a $1 increase in taxes decreases
aggregate demand.
So when both government expenditure and taxes increase
by $1, aggregate demand increases.
Stabilizing the Business Cycle

Discretionary Fiscal
Stabilization
Figure 30.13 shows how
fiscal policy might close a
recessionary gap.
An increase in government
expenditure or a tax cut
increases aggregate
demand.
The multiplier process
increases aggregate
demand further.
Stabilizing the Business Cycle

Figure 30.14 shows how

fiscal policy might close an
inflationary gap.
A decrease in government
expenditure or a tax
increase decreases
aggregate demand.
The multiplier process
decreases aggregate
demand further.
Stabilizing the Business Cycle

Limitations of Discretionary Fiscal Policy

The use of discretionary fiscal policy is seriously
hampered by three time lags:
 Recognition lag—the time it takes to figure out that fiscal
policy action is needed.
 Law-making lag—the time it takes Congress to pass the
laws needed to change taxes or spending.
 Impact lag—the time it takes from passing a tax or
spending change to its effect on real GDP being felt.
Stabilizing the Business Cycle

Automatic Stabilizers
Automatic stabilizers are mechanisms that stabilize real
GDP without explicit action by the government.
Induced taxes and needs-tested spending are automatic
stabilizers.
Taxes that vary with real GDP are called induced taxes.
When real GDP increases in an expansion, wages and
profits rise, so the taxes on these incomes—induced taxes
—rise.
When real GDP decreases in a recession, wages and
profits fall, so the induced taxes on these incomes fall.
Stabilizing the Business Cycle

The spending on programs that pay benefits to suitably

qualified people and businesses is called needs-tested
spending.
When the economy is in a recession, unemployment is high
and needs-tested spending on unemployment benefits and
food stamps increases.
When the economy expands, unemployment falls, and
needs-tested spending decreases.
Induced taxes and needs-tested spending decrease the
multiplier effects of changes in autonomous expenditure.
So they moderate both expansions and recessions and
make real GDP more stable.
Stabilizing the Business Cycle

Budget Deficit Over the

Business Cycle
Figure 30.15 shows the
budget deficit over the
business cycle from 1980 to
2005.
Recessions are highlighted.
During a recession, the
budget deficit increases.
Stabilizing the Business Cycle

Cyclical and Structural Balances

The structural surplus or deficit is the surplus or deficit
that would occur if the economy were at full employment
and real GDP were equal to potential GDP.
The cyclical surplus or deficit is the actual surplus or
deficit minus the structural surplus or deficit; that is, it is
the surplus or deficit that occurs purely because real GDP
does not equal potential GDP.
Stabilizing the Business Cycle

Figure 30.16 illustrates

the distinction between a
structural and cyclical
surplus and deficit.
In part (a), potential GDP
is $12 trillion.
As real GDP fluctuates
around potential GDP, a
cyclical deficit or cyclical
surplus arises.
Stabilizing the Business Cycle

In part (b), if real GDP

and potential GDP are
$11 trillion, the budget
deficit is a structural
deficit.
If real GDP and potential
GDP are $12 trillion, the
budget is balanced.
If real GDP and potential
GDP are $13 trillion, the
budget surplus is a
structural surplus.
THE END