Chapter 28
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Chapter 28. Managing Aggregate Demand: Fiscal Policy. Next, let us turn to the problems of our fiscal policy. Here the myths are legion and the truth hard to find. JOHN F. KENNEDY. Income Taxes & Consumption Schedule. Fiscal policy Government’s plan for spending & taxation

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Chapter 28

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Chapter 28

Managing Aggregate Demand:

Fiscal Policy

Next, let us turn to the problems of our fiscal policy.

Here the myths are legion and the truth hard to find.

JOHN F. KENNEDY


Income Taxes & Consumption Schedule

  • Fiscal policy

    • Government’s plan for spending & taxation

    • To steer aggregate demand

      • Desired direction

  • Disposable income (DI = Y-T)

    • Real GDP (Y)

    • Taxes (T)


Income Taxes & Consumption Schedule

  • Tax increase

    • Consumption schedule – shift downward

    • Total spending schedule – shift downward

    • Equilibrium GDP (demand side) – reduced

  • Tax decrease

    • Consumption schedule – shift upward

    • Total spending schedule – shift upward

    • Equilibrium GDP (demand side) - increased


Figure 1

How tax policy shifts the consumption schedule

C

Tax Increase

Tax Cut

Real Consumer Spending

Real GDP


The Multiplier Revisited

  • Change in government purchases

    • Every dollar - spent

    • Multiplier effect

  • Change in taxes

    • Not every dollar is spent

    • Multiplier – smaller


The Multiplier Revisited

  • Multiplier

    • Reduced by income tax

    • Income tax

      • Reduces - fraction of each dollar of GDP

        • Consumers actually receive and spend

  • Oversimplified formula 1/(1-MPC)

    • Overstates multiplier

      • Ignores variable imports

      • Ignores price-level changes

      • Ignores income tax


Figure 2

The multiplier in the presence of an income tax

45°

E1

E0

C+I+G1+(X-IM)

C+I+G0+(X-IM)

$400

Real Expenditure

0

Real GDP

7,000

6,000


The Multiplier Revisited

  • Taxes – change multiplier analysis

    • Tax changes - smaller multiplier effect

      • Than changes in spending

    • Income tax - reduces multipliers for

      • Tax changes

      • Changes in spending


The Multiplier Revisited

  • Automatic stabilizer

    • Feature of economy

    • Reduces its sensitivity to shocks

      • Sharp increase/decrease in spending

    • Automatically – shock absorber

      • Lower multiplier

    • E.g.

      • Personal income tax

      • Unemployment insurance


The Multiplier Revisited

  • Government transfer payments

    • Payments to individuals

      • Not compensation for production

    • Add to income

    • Function as negative taxes

    • T = taxes - transfers


Planning Expansionary Fiscal Policy

  • Expansionary fiscal policy

    • Raise government purchases

    • Reduce taxes

    • Increase transfer payments

  • To close recessionary gap

    • Between actual and potential GDP


Figure 3

Fiscal policy to eliminate a recessionary gap

Potential

GDP

Potential

GDP

F

E

45°

45°

Recessionary

gap

Real Expenditure

Real Expenditure

C+I+G0+(X-IM)

C+I+G0+(X-IM)

C+I+G1+(X-IM)

6,000

0

0

7,000

7,000

6,000

(a)

(b)

Real GDP

Real GDP


Planning Contractionary Fiscal Policy

  • Contractionary fiscal policy

    • Reduce government purchases

    • Increase taxes

    • Reduce transfer payments

  • To close inflationary gap

    • Between actual and potential GDP

  • Can avoid inflation


Choice: Spending Policy & Tax Policy

  • Higher spending & lower taxes

    • Same aggregate demand curve

    • Same increases in real GDP and prices

  • Active fiscal policy

    • Smaller public sector

    • Larger public sector


Figure 4

Expansionary fiscal policy

S

D0

D1

E

A

Price Level

Rise in

real GDP

Rise in

Price level

D0

D1

S

Real GDP


Choice: Spending Policy & Tax Policy

  • Advocates - bigger government

    • Expand demand

      • Higher government spending

    • Contract demand

      • Tax increase

  • Advocates - smaller government

    • Expand demand

      • Cut taxes

    • Reduce demand

      • Cut expenditures


Some Harsh Realities

  • Complications

    • I, X-IM, C schedules

      • Shift with

        • Expectations, Technology

        • Events abroad, Other factors

    • Multipliers – not precisely known

    • Target - full-employment GDP

      • Dimly visible

    • Fiscal policies

      • Time lags


Some Harsh Realities

  • Change unemployment rate

    • Long-run costs

      • Running large budget deficits

    • Inflationary cost

      • How large

  • Supply-side economics


Idea Behind Supply-Side Tax Cuts

  • Certain types of tax cuts

    • Increase aggregate supply

      • Increase supply of labor & capital

      • Reduce inflation

      • Raise real GDP

    • Lower personal income tax rates

    • Reduce taxes on income from savings

    • Reduce taxes on capital gains

    • Reduce the corporate income tax


Figure 5

The goal of supply-side tax cuts

S0

S1

D

A

B

Price Level

D

S0

S1

Real GDP


Figure 6

A successful supply-side tax reduction

S0

S1

D0

D1

E

A

C

Price Level

D0

D1

S0

S1

Real GDP


Idea Behind Supply-Side Tax Cuts

  • Undesirable side effects

    • Small magnitude of supply-side effects

    • Demand-side effects

    • Problems with timing

    • Effects on income distribution

    • Losses of tax revenue


Figure 7

A more pessimistic view of supply-side tax cuts

S0

D0

D1

S1

E

C

Price Level

D0

D1

S0

S1

Real GDP


Idea Behind Supply-Side Tax Cuts

  • Supply-side tax cuts

    • Effectiveness

      • Depends on what kinds of taxes are cut

        • Stimulate business investment - greater impact

    • Increase aggregate supply - more slowly

      • Than - increase aggregate demand

      • Faster economic growth in long run


Idea Behind Supply-Side Tax Cuts

  • Supply-side tax cuts

    • Demand-side effects

      • Overwhelm supply-side effects in short run

    • Likely to widen income inequalities

    • Lead to larger budget deficits


Graphical treatment of taxes and fiscal policy

  • Variable taxes

    • Vary with GDP

    • Personal income tax

    • Corporate income tax

    • Sales tax

  • Fixed taxes

    • Don’t vary with GDP

    • Property taxes


Figure 8

How variable taxes shift the consumption schedule

C

Variable Tax Cut

Variable Tax Increase

Real Consumer Spending

Real GDP


Graphical treatment of taxes and fiscal policy

  • Variable taxes

    • Flatten the consumption schedule

  • Government purchases (goods & services)

    • Add to total spending - directly

      • C + I + G + (X – IM)


Graphical treatment of taxes and fiscal policy

  • Higher taxes

    • Reduce total spending – indirectly

      • Lower disposable income

      • Reduce: C component of C + I + G + (X – IM)

  • Government’s actions

    • Raise or lower equilibrium level of GDP

    • Depends on

      • Spending

      • Taxing


Figure 9

Consumption schedule with fixed vs. variable taxes

C1

C2

Real Consumer Spending

Real GDP


Table 1

Effects of an income tax on consumption schedule


Table 2

The relationship between consumption and GDP


Table 3

Total expenditure schedule with a 20% income tax


Figure 10

Income determination with a variable income tax

45°

8,000

E

7,000

C+I+G+(X-IM)

Real Expenditure

6,000

5,000

4,000

3,000

0

4,000

6,000

8,000

Real GDP


Multipliers for tax policy

  • Tax multiplier for fixed taxes

    • Change in tax

      • Change in consumer spending

    • Vertical shift of consumption schedule


Figure 11

The multiplier for a reduction in fixed taxes

45°

C0+I+G+(X-IM)

C1+I+G+(X-IM)

Real Expenditure

$300

billion

6,000

6,750

Real GDP


Algebraic treatment of fiscal policy

  • Y=C+I+G+(X-IM)

  • C=a+bDI

  • DI=Y-T

  • T=T0+tY

  • C=a-bT0+b(1-t)Y


Algebraic treatment of fiscal policy


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