Fiscal Policy
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Fiscal Policy Defined
The government’s
(Congress and the President)
use of taxing and spending to promote
economic growth and stability
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History of Fiscal Policy
Laissez-faire (classical
economics)
The Great Depression
1929 – 1930’s
WWII
1939 - 1945
•No need for government
interference
•Market regulates itself
•Adam Smith, David
Ricardo, Thomas Malthus
are classical economists
•Challenged classical
economics
•FDR increased
government spending on
programs to increase
employment on public
works to help stop the
depression
•To prepare for war, U.S.
increased production of
war goods.
•Government spending
increased dramatically
which helped the country
out of the depression.
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History of Fiscal Policy
1960’s
1980’s
•JFK proposed tax cuts to personal
and business income taxes to increase
aggregate demand.
•Government spending increased due
to the Vietnam War.
•Reagan passed a bill to reduce taxes
by 25% over 3 years to fight stagflation
(high unemployment + high inflation).
•Demand-side policies would not work,
thus supply-side policies were
introduced – known as Reaganomics.
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Two Branches of Fiscal
Policy:
1. Demand-side
2. Supply-side
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Demand-Side Economics
Inspired by John Maynard Keynes
during the Great Depression and is
also called Keynesian Fiscal Policy
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Looks at changing aggregate demand
which is either increasing or
decreasing
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Tools of Fiscal Policy
1. Taxing Policy of Government
2. Spending Policy of Government
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Aggregate Demand is
C + I + G + (F) = GDP
Changes in business (I) spending is the
most volatile and this will cause the
most economic instability.
To offset this, the government can
compensate by changing their taxing
and spending to maintain a stable level
of GDP.
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Demand-Side Fiscal Policy
Keynes said that sometimes the market
could not correct itself and the
government needs to take a more active
role in the economy.
This increased role of government in the
economy was something different from
the classical view. It was considered very
radical for the time.
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Limitations of Demand-Side
Fiscal Policy
1.
Not coordinated with monetary policy
2.
Surplus budget unpopular and politicians lack the
political will to carry it out
3.
Time lags - inside lags and outside lags
4.
People are unpredictable. Economics is a social
science so we are dealing with human behavior.
5.
Doesn’t solve stagflation
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Multiplier Effect
• The multiplier effect in fiscal policy states
that for every one dollar change in taxing
or government spending, it will create a
greater change in the national income,
either increasing or decreasing.
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Fiscal Policy – Supply-Side
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Supply-Side Fiscal Policy
• Economic policies designed to stimulate
output (GDP) and lower unemployment. To
achieve this you increase aggregate
supply (AS).
• Contemporary supply-side was
implemented in the 1980’s to deal with
stagflation and is sometimes called
“Reaganomics.”
• Goal is to give incentives to businesses to
produce more ( AS).
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Principles of Supply Side
1. Tax cuts encourage consumers to save
so businesses have money to borrow for
capital investment.
2. Government spending cuts especially on
transfer payments where nothing is
produced
3. Deregulate business
Overall Less Government
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When AS increases increase GDP
PL
AS1
AS2
AD
Q1
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GDP
Q2
Q
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When AS increases price goes down
PL
AS1
AS2
P1
P2
AD
Q
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Supply-Side Economics
• Stresses the influence of taxation on the
economy. Supply-siders believe that taxes
have a strong, negative influence on output.
• Arthur Laffer came up with a theory
concerning tax rates and tax revenues. It
was called the Laffer Curve. Laffer said if
you lower the tax rate, we will see an
increase in tax revenue.
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Laffer Curve
T 100%
a
x
R
a
t
e
s
A
B
C
D
E
0%
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Tax Revenues
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Laffer Curve
100%
Govt. will collect no
revenue at two tax
rates, 0% and 100%.
T
a
x
With 100% tax rate,
workers lose all
incentive to work (no
disposable personal
income) and at 0% tax
rate the government
will collect 0 revenue.
R
a
t
e
s
0%
Tax Revenues
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Laffer Curve
100%
T
a
x
R
a
t
e
s
A
B
C
E
0%
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D
As we move
from A to B,
tax rate is
lowered and
we increase
tax revenue.
Tax Revenues
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Laffer Curve
100%
T
a
x
R
a
t
e
s
C
Point C is the
optimum tax rate.
Higher tax rates
decrease worker
incentives.
Below C we decrease
the revenue.
0%
Tax Revenues
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PROBLEM: We don’t
know where we are on
the curve.
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Limitations
1. Lack of experience - hasn’t been around
long enough
2. Don’t know where we are on Laffer Curve
3. Makes Federal Income Tax less
progressive and reduces the automatic
stabilization and reduces many “safety
net” programs
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Taxing & Spending
DECIDING FISCAL POLICY
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When the U.S. Government
decides Fiscal Policy:
• They are deciding which goal to address
at a given time – economic growth,
stability or full employment.
• They must decide to tax or spend to
address the problems in the economy.
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Taxation
• Power to Tax – Article 1, Section 8, Clause 1 of
the U.S. Constitution
• 16th Amendment
• Limitations:
– Purpose is for “the common defense and general
welfare”
– Federal taxes must be the same in every state
– Government may not tax exports
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Purposes of Taxation
•Raise revenue
•Regulate the economy (fiscal policy)
•Redistribution of income (transfer
payments)
•Provide positive economic incentives
•Provide negative economic incentives
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Types of Taxes or Tax Structures
•Progressive - takes larger percent of
income from higher income groups as income goes up tax rate increases
•example- Federal Income Tax
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Types - Regressive
• Regressive - takes larger percent of
income from the lower income group
• Example - sales tax, property tax, Social
Security tax
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Types - Proportional
•Proportional - takes the same percent
of income from all income levels
•Examples - some state income taxes &
proposed flat tax
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Principles of Taxation
1.
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Benefits received - people who
directly benefit or use the good
or service should pay
• Example - Excise tax on
gasoline used to build roads
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2. Ability-to-pay - people who
have more wealth or income
should pay more
• Example - Federal Income
Tax
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Top Federal Taxes
• Individual Income Tax
• Social Security
• Corporate Income Tax
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Federal Taxes
Ind. Income Tax
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
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Corp. Income
Tax
Social Security
Excise Taxes
Estate & gift
Customs
Other
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FICA
• FICA=Social Security + Medicare
• FICA Taxable Wage Base or a cap - a
maximum income level that can be taxed.
All income above that level is not taxed for
FICA, tax free.
• Employers match employee contributions.
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State Taxes
• States receive most of their revenue from
a sales tax.
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Local Taxes
• Property Tax
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Who Bears the Burden
of a Tax?
To fully evaluate the fairness of a tax, it is
important to think about who bears the final
burden of the tax or the incidence of a tax.
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Government Spending
• Goods and Services
• Transfer Payments
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