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Fiscal Policy. Taxing and spending decisions by government (Congress and President). I. Demand-Side Economics. Keynes: GD because neither producers nor consumers had incentive to spend enough to cause increase in production Washington Baby Sitter Co-op

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fiscal policy

Fiscal Policy

Taxing and spending decisions by government (Congress and President)

i demand side economics
I. Demand-Side Economics
  • Keynes: GD because neither producers nor consumers had incentive to spend enough to cause increase in production
    • Washington Baby Sitter Co-op
  • Role for government: counter-cyclical—spend/cut taxes during recession, raise taxes/cut spending during expansion
  • Pump-priming
    • Works best in “liquidity trap” (interest rates 0%) otherwise monetary policy better (crowding out, inefficiencies + disincentives)
    • Political “realities”: spending easy in recession, cuts hard in boom years procyclical policies and budget deficits + debt (see below)
      • May not actually be true: see, 1990s and 2010s
Multiplier Effect: for every one dollar change in fiscal policy creates a greater than one dollar change in national income
  • Gov Bob  Jane  Nate  etc.

1/MPS or 1/(1-MPC)

Marginal Propensity to Save / Consume

  • Complex multiplier:2x
    • Strongest horizontal, less intermediate, 0 vertical
  • Balanced Budget multiplier: 1x spending change
    • So: Cutting government spending by $66B and cutting taxes by $66B will drop GDP by $66B and increase unemployment
Automatic Stabilizers: government programs that change automatically depending on GDP and personal income (counter-cyclical)
    • Transfer payments: welfare, Medicare
    • Taxes (iffprogressive; regressive destabilizes)
      • Progressive: more $ more % (federal income)
      • Regressive: less $ more % (sales tax)
      • Flat: all same %

Inelastic demand consumers pay most of tax (e.g. gas)

[+ inelastic supply

Elastic demand producers pay most of tax

true tax burden
True Tax Burden
  • Lost consumer/producer surplus: $1,000/gallon milk tax no milk produced no tax revenue but loss consumer/producer surplus
  • IF leads to reallocation to more efficient usages, then no burden
    • E.g. tax negative externalities and fund positive externalities
ii supply side economics
II. Supply-Side Economics

Focus on Aggregate Supply and freeing up private sector to reduce costs and shift AS right

Policy prescriptions:

  • Deregulation (reduce costs + increase competition + efficiency: false natural monopolies)
  • Adverse effects gov’t spending (esp. welfare)
  • Focus disincentive effect of taxes
    • Example: raising corporate taxes reduces incentive to produce and hire
    • Progressive (higher income higher %), regressive (lower income higher %:speeding ticket, sales tax), flat (all same %)
    • Federal: progressive marginal
      • Brackets
General agreement: tax cuts inc AS in long run (but probably more AD short run)
    • (disagreement costs + benefits)
  • Major point divergence w/in SS: Laffer Curve + Reagonomics

“Trickledown” vs. GHWB: “Voodoo Economics”

“Dynamic” vs. “Static” scoring

Problems with Reaganomics
    • 1) Doesn’t work as advertised: 1980s, 2000s: massive deficits (+ massive debt); rich don’t invest more (a) cutting income tax encourages earning income rather than investment, b) lack of viable investments)
  • 2) Top marginal tax rates already low [high 90% in 1940s, 70% 1960, 30% 1990; Clinton tax increase 200040%: revenue up, growth up (doesn’t disprove, but seriously questions)] rich richer, poor poorer
  • 3) Crisis

(you didn’t really expect nothing to ever go wrong did you Pollyana?)

    • 4) Efficiency can be the enemy of stability (and growth in the long run: static efficiency vs. creative destruction)
econ 101 works
Econ 101 Works
  • Expansionary fiscal policy is expansionary; contractionary fiscal policy is contractionary
post wwii gdp growth by administration
Post-WWII GDP Growth by Administration
  • #1: Kennedy-Johnson (49 percent over eight years)
  • #2: Clinton (34 percent)
  • #3: Reagan (32 percent)
  • #4: Nixon-Ford (24 percent)
  • #5: Eisenhower (21 percent)
why doesn t work
Why doesn’t work?
  • Marginal Propensity to Consume (MPC) vs. Marginal Propensity to Save (MPS)
    • MPC .75 $6.67 B to increase AD $5B
      • $1.67 in S
  • If tax cut goes to wealthy, MPC even lower tax cut must be even larger
    • 2003 tax cuts: $726 B in cuts to create 1.4 million jobs
    • 726/1.4= little over $500,000
    • Average US job pays $40,000 x 10 years= $400,000
      • Actual job creation: 0 (would have been negative even before recession except for public sector growth)
  • Well, what about savings and investment?
    • US savings rate practically 0, if not negative
    •  “Supply-side” tax cuts primarily effect demand (C+I), especially in short term
  • Also, Federal tax cuts less money to States (e.g. education, Medicare) spending cuts (AD) or tax increase (regressive State taxes, AD; “50 Herbert Hoovers”)
lucky duckies
Lucky Duckies
  • Wall Street Journal Op-ed (Nov 2002): tax system creates 2 classes: those who pay huge taxes and those who pay none (don’t have “blood boiling with tax rage”) don’t see costs of gov’t don’t support “tax relief”
    • Top 50% pay 96% of federal income taxes
    • Top 5% pay 56% of federal income taxes
    • + Earned Income Tax Credit (EITC): compromise in 1996 Welfare Reform act
  • “Say a person earns $12,000. After subtracting the personal exemption, the standard deduction and assuming no tax credits, then applying the 10% rate of the lowest bracket, the person ends up paying a little less than 4% of income in [Federal income] taxes. It ain't peanuts, but not enough to get his or her blood boiling with tax rage.”
  • “Workers who pay little or no taxes can hardly be expected to care about tax relief for everybody else. They are also that much more detached from recognizing the costs of government.” (vote Democratic)
  • Suggestion: should raise taxes on the poor to get them to vote for “tax relief” (vote Republican)
  • 1) Poor people vote much lower rate
  • 2) The rich benefit more from gov’t: over $100,000 got $9,280 in benefits; under $10,000 got $5,560 (in 1992, probably worse now)
    • Whole argument for progressive taxes to begin with: William Jennings Bryan (1894)—"Who is it most needs a navy? Is it the farmer who plods along behind the plow upon his farm, or is it the man whose property is situated in some great seaport where it could be reached by an enemy's guns?"
  • 3) Tax code isn’t progressive when add all taxes
iii the budget
III. The Budget
  • Deficit: the amount the government spends more than it takes in (2010 $1.4 trillion; 2013 $680 billion)
    • Surplus: takes in more than spends
  • Debt: all the money the federal government owes to bondholders (2013: $17 trillion; mostly to US citizens)
problems with debt deficit
Problems with Debt / Deficit
  • 1) Crowding-out: investment in government bonds means less money available for private investment
    • Unless: a) money wasn’t going to be borrowed/invested anyway (GD), or b) Fed easy money (offsets IR up; “zero lower bound”: 2007 on)

If the government deficit spends, where does

it get the money?

It must borrow in the Loanable Funds Market.


What entities demand

money in the loanable

funds market?

As the government

borrows money in

the loanable funds

market, money

demand increases







causing interest rates

to go up.



Loanable Funds








Loanable Funds

Higher interest rates

crowd out private

borrowing that

would have occurred

at the lower interest


2) Servicing the debt: interest payments
  • 3) Deficit inflation higher interest rates slower economy less tax revenue more deficit
  • 4) Default? How secure are US bonds? $45 trillion Medicare and Social Security “debt”
    • (add up future deficits, discount to today’s $s)
net exports effect
Net Exports Effect
  • Crowding-out higher IR greater demand US financial assets (bonds, savings accounts, etc.) greater demand US $ $ value up US goods more expensive compared foreign goods (foreign cheaper) exports down + imports up GDP down (partially offsets expansionary policy)