Ch. 10: Fiscal Policy
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Fiscal Policy
• Refers to changes in government
expenditures and/or taxes to achieve
particular economic goals, such as low
unemployment, price stability, and
economic growth.
• Government expenditures is the sum of
government purchases and transfer
payments.
Fiscal Policy Definitions
• Expansionary fiscal policy
refers to increases in
government expenditures
and/or decreases in taxes
to achieve macroeconomic
goals.
• Contractionary fiscal
policy attempts to
decrease government
expenditures and/or
increases in taxes to
achieve macroeconomic
goals.
Fiscal Policy Definitions
• Discretionary Fiscal
Policy is deliberate
changes of government
expenditures and/or taxes
to achieve particular
economic goals.
• Automatic Fiscal Policy is
changes in government
expenditures and/or taxes
that occur automatically
without (additional)
congressional action.
Two Key Assumptions
• In our discussion of fiscal policy, we only
deal with discretionary fiscal policy.
• We assume that any change in government
spending is due to a change in government
purchases and not to a change in transfer
payments.
Demand-Side Fiscal Policy
• A change in consumption, investment,
government purchases, or net exports can
change aggregate demand and there fore
shift the AD curve.
• A change in taxes can affect consumption or
investment or both and there for can affect
aggregate demand.
Fiscal Policy: A Keynesian
Perspective
Crowding Out
• Refers to a decrease in private expenditures that
occurs as a consequence of increased government
spending or the financing needs of a budget
deficit.
• Economists who believe the crowding out
phenomenon exists argue that because of the direct
substitution of public services for consumer
spending or because of higher interest rates,
increases in government spending induce
consumers and investors to spend less.
Crowding Out
• Complete Crowding Out occurs when the decrease
in one or more components of private spending
completely offsets the increase in government
spending.
• Incomplete Crowding Out occurs when the
decrease in one or more components of private
spending only partially offsets the increase in
government spending.
• If complete or incomplete crowding out occurs, it
follows that expansionary fiscal policy will have
less impact on aggregate demand and Real GDP
than Keynesian theory predicts.
• In Keynesian theory,
expansionary fiscal policy
shifts the aggregate
demand curve to AD2 and
moves the economy to
point 2.
• If there is no crowding out,
expansionary fiscal policy
increases Real GDP and
lowers the unemployment
rate.
• If there is incomplete
crowding out, expansionary
fiscal policy increases Real
GDP and lowers the
unemployment rate, but not
as much as in the case of
zero crowding out.
• If there is complete
crowding out, expansionary
fiscal policy has no effect
on the economy.
Keynesian Theory &
Crowding Out
The New Classical View of
Fiscal Policy: Crowding Out with No
Increase in Interest Rates
•
Individuals respond to expansionary fiscal policy, a larger
deficit, and greater deficit-financing requirements by
thinking the following “A larger deficit implies more debt
this year and higher future taxes. I’ll simply save more in
the present so I can pay the higher future taxes required to
pay interest and to repay principal on the new debt. But,
of course, if I’m going to save more, I’ll have to consume
less.
1. Current consumption will fall as a result of expansionary
fiscal policy.
2. Deficits do not bring higher interest rates.
The New Classical View of
Expansionary Fiscal Policy
• As long as
expansionary
fiscal policy is
translated into
higher future
taxes, there will
be no change in
Real GDP,
unemployment,
the price level,
or interest rates.
Lags And Fiscal Policy
1.
2.
3.
4.
5.
The Data Lag
The Wait-And-See Lag
The Legislative Lag
The Transmission Lag
The Effectiveness Lag
Some economists argue that discretionary fiscal
policy is not likely to have the impact on the
economy that policymakers hope. By the time
the full impact of the policy is felt, the economic
problem it was designed to solve may no longer
exist, may not exist to the degree it once did, or
it may have changed altogether.
Lags And Fiscal Policy
The government
has moved the
economy from
point 1 to point 2,
and not, as they
had hoped, from
point 1 to point 1’.
Demand-Side Fiscal Policy: Return to the
Keynesian Model
It would seem that
under the conditions
of no lags and zero
crowding out,
expansionary fiscal
policy – either
increasing
government spending
or cutting taxes – will
work at removing the
economy from a
recessionary gap.
Demand-Side Fiscal Policy: Return to the
Keynesian Model
If government
knows the
difference between
Q1 and QN (so that
it knows how
much to change
Real GDP) and it
knows the MPC,
then it can use
fiscal policy to get
the economy out
of a recessionary
gap and producing
Natural Real GDP.
Demand-Side Fiscal Policy: Return to the
Keynesian Model
• If the government
doesn’t know the
actual MPC and it
doesn’t know the
actual difference
between Q1 and
QN, then fiscal
policy isn’t likely
to work as
intended.
Tax Cuts Instead: Are Things
Any Different?
• An important equation:
 Real GDP = -MPC(m) x T
• A dollar spend by government is a dollar
spent; a dollar tax cut is a dollar partly
saved and partly spent. In order to get the
same change in Real GDP, government has
to cut taxes more than it has to raise
purchases.
Q&A
• How does crowding out question the
effectiveness of expansionary demand-side
fiscal policy?
• Do budget deficits raise interest rates?
• How can an increase in the size of the
federal budget deficit affect the trade
deficit?
Supply-Side Fiscal Policy
• All other things held constant, lower marginal tax rates
increase the incentive to engage in productive activities
relative to leisure and tax avoidance activities.
• Marginal Tax Rate = (Δ Tax payment)/(Δ Taxable
Income)
• Given a cut in marginal tax rates two things will happen:
Individuals will have more disposable income; the
amount of money they can earn by working increases.
• In the analysis of marginal tax rates and aggregate
supply, we implicitly assume that in the aggregate, a
marginal tax rate cut increases work activity.
The Predicted Effect of a Permanent
Marginal Tax Rate Cut on Aggregate
Supply
The Laffer Curve: Tax Rates and
Tax Returns
• If income tax rates were lowered, would it increase
or decrease tax revenue?
• There are two tax rates at which zero tax revenues
will be collected – 0 and 100%.
• An increase in tax rates could cause tax revenues to
increase.
• A decrease in tax rates could cause tax revenues to
increase.
• Tax revenues = (Tax base) x (the average Tax rate)
The Laffer Curve: Tax Rates and
Tax Returns
The Laffer Curve: Implications
• We assume that as the tax rate is reduced, the tax
base expands. The rationale is that individuals work
more, invest more, and enter into more exchanges,
and shelter less income from taxes and lower tax
rates.
• How much does the tax base expand following the
tax rate reduction?
• Tax revenues increase if a tax reduction is made in
the downward-sloping portion of the curve (between
points B and C); tax revenues decrease following a
tax rate reduction in the upward sloping portion of
the curve (between points A and B).
Macroeconomics Intermission
How Does the
Economy Work?
– Is it Self-regulating?
– Is it Inherently
unstable?
– Will a fiscal policy
have its intended
effect?
Q&A
• Give an arithmetical example to illustrate
the difference between the marginal and
average tax rates.
• If income tax rates rise, will income tax
revenue rise as well?