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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

- Reduces - fraction of each dollar of GDP

- Oversimplified formula 1/(1-MPC)
- Overstates multiplier
- Ignores variable imports
- Ignores price-level changes
- Ignores income tax

- Overstates multiplier

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

- Tax changes - smaller multiplier effect

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

- Payments to individuals

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

- Expand demand
- Advocates - smaller government
- Expand demand
- Cut taxes

- Reduce demand
- Cut expenditures

- Expand demand

Some Harsh Realities

- Complications
- I, X-IM, C schedules
- Shift with
- Expectations, Technology
- Events abroad, Other factors

- Shift with
- Multipliers – not precisely known
- Target - full-employment GDP
- Dimly visible

- Fiscal policies
- Time lags

- I, X-IM, C schedules

Some Harsh Realities

- Change unemployment rate
- Long-run costs
- Running large budget deficits

- Inflationary cost
- How large

- Long-run costs
- 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

- Increase aggregate supply

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

- Depends on what kinds of taxes are cut
- Increase aggregate supply - more slowly
- Than - increase aggregate demand
- Faster economic growth in long run

- Effectiveness

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

- Demand-side effects

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)

- Add to total spending - directly

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)

- Reduce total spending – indirectly
- Government’s actions
- Raise or lower equilibrium level of GDP
- Depends on
- Spending
- Taxing

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

- Change in tax

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

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