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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

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
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 schedule1
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
Figure 1

How tax policy shifts the consumption schedule

C

Tax Increase

Tax Cut

Real Consumer Spending

Real GDP


The multiplier revisited
The Multiplier Revisited

  • Change in government purchases

    • Every dollar - spent

    • Multiplier effect

  • Change in taxes

    • Not every dollar is spent

    • Multiplier – smaller


The multiplier revisited1
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
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 revisited2
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 revisited3
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 revisited4
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
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
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
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
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
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 policy1
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
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 realities1
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
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
Figure 5

The goal of supply-side tax cuts

S0

S1

D

A

B

Price Level

D

S0

S1

Real GDP


Figure 6
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 cuts1
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
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 cuts2
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 cuts3
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
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
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 policy1
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 policy2
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
Figure 9

Consumption schedule with fixed vs. variable taxes

C1

C2

Real Consumer Spending

Real GDP


Table 1
Table 1

Effects of an income tax on consumption schedule


Table 2
Table 2

The relationship between consumption and GDP


Table 3
Table 3

Total expenditure schedule with a 20% income tax


Figure 10
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
Multipliers for tax policy

  • Tax multiplier for fixed taxes

    • Change in tax

      • Change in consumer spending

    • Vertical shift of consumption schedule


Figure 11
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
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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