Chapter 13
Fiscal Policy
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Introduction
Government expenditures on health care services have grown
significantly since federal and state government began covering
payments for various types of health-related expenses in the
mid-1960s.
Today, government health care expenditures account for more
than 30% of all federal government spending and as much as
35% of state government spending.
Do on-going increases in government health care spending
generate dollar-for-dollar increases in total planned
expenditures in the U.S.? Do higher government health care
expenditures displace a portion of private health care spending?
13-2
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Learning Objectives
• Use traditional Keynesian analysis to
evaluate the effects of discretionary fiscal
policy
• Discuss ways in which indirect crowding out
and direct expenditure offsets can reduce
the effectiveness of fiscal policy actions
• Explain why the Ricardian equivalence
theorem calls into question the usefulness
of tax changes
13-3
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Learning Objectives (cont'd)
• List and define fiscal policy time lags and
explain why they complicate efforts to
engage in fiscal “fine tuning”
• Describe how certain aspects of fiscal policy
function as automatic stabilizers for the
country
13-4
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Chapter Outline
• Discretionary Fiscal Policy
• Possible Offsets to Fiscal Policy
• Discretionary Fiscal Policy in Practice:
Coping with Time Lags
• Automatic Stabilizers
• What Do We Really Know About Fiscal
Policy?
13-5
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Did You Know That...
• When President Woodrow Wilson signed into law the U.S.
federal income tax on October 1913, only about 1% of the
U.S. population owed any income taxes.
• The Tax Foundation estimates that for $1 that households
earning less than $24,000 per year pay in taxes, they get
back transfers and services valued at $8.21.
• Every year, the government collects nearly $3 trillion in tax
payments. The government spends $0.5 trillion more than
this by borrowing the additional funds.
• In this chapter, you will learn about how variations in taxes
and government spending affect real GDP and the price level.
13-6
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Discretionary Fiscal Policy
• Fiscal Policy
– The discretionary changes in government
expenditures and/or taxes in order to achieve
certain national economic goals, such as:
• High employment (low unemployment)
• Price stability
• Economic growth
• Improvement of international payments balance
13-7
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Discretionary Fiscal Policy
(cont'd)
• An increase in government spending will
stimulate economic activity
• Changes in government spending
– Military spending
– Education spending
– Budgets for government agencies
13-8
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Figure 13-1 Expansionary and Contractionary
Fiscal Policy: Changes in Government Spending,
Panel (a)
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand
13-9
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Figure 13-1 Expansionary and Contractionary
Fiscal Policy: Changes in Government Spending,
Panel (b)
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand
13-10
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Discretionary Fiscal Policy
(cont'd)
• Questions
– Would the increase in government spending
equal the size of the gap?
– What impact would expansionary fiscal policy
have on the price level?
13-11
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Figure 13-2 Contractionary and Expansionary
Fiscal Policy: Changes in Taxes, Panel (a)
• In panel (a), the economy is
initially at E1, where real GDP
exceeds long-run equilibrium
• Contractionary fiscal policy can
move aggregate demand to
AD2 via a tax increase
• A new equilibrium is at E2 at a
lower price level
• Real GDP is now consistent
with LRAS
13-12
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Figure 13-2 Contractionary and Expansionary
Fiscal Policy: Changes in Taxes, Panel (b)
• In panel (b) with a
recessionary gap (in this case
$500 billion) taxes are cut
• AD1 moves to AD2
• The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
• We are at the long-run
equilibrium level
13-13
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Discretionary Fiscal Policy
(cont'd)
• Change in taxes
– A rise in taxes causes a reduction in aggregate
demand because it can reduce consumption
spending, investment expenditures, and net
exports.
13-14
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Discretionary Fiscal Policy
(cont'd)
• Question
– What would be the long-run impact of a tax cut
on real GDP if the economy is at fullemployment equilibrium?
13-15
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International Policy Example: Struggling to
Boost Government Spending in Peru
• The president of Peru sought $1 billion in new
expenditures on roads, drinking water facilities, and
improvements to schools/hospitals. Five months later,
only $160 million had been spent.
• Peru’s system requires national government spending to
be coordinated with regional governments, so the
president had to coordinate with 23 new governors.
• Why did the $160 million in government spending after
five months likely shift Peru’s aggregate demand curve
rightward by more than that amount?
13-16
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Possible Offsets to Fiscal Policy
• Fiscal policy does not operate in a vacuum
and important questions must be answered.
– How are expenditures financed and by whom?
– If taxes are increased what does government do
with the taxes?
– What will happen if individuals worry about
increases in future taxes?
13-17
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Possible Offsets to Fiscal Policy
(cont'd)
• Crowding-Out Effect
– The tendency of expansionary fiscal policy to
cause a decrease in planned investment or
planned consumption in the private sector; this
decrease normally results from the rise of
interest rates.
13-18
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Figure 13-3 The Crowding-Out
Effect, Step by Step
13-19
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Figure 13-4 The Crowding-Out
Effect
Expansionary policy causing
deficit spending initially shifts
from AD1 to AD2
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap
13-20
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Possible Offsets to Fiscal Policy
(cont'd)
• Planning for the future:
the Ricardian equivalence theorem
– Ricardian Equivalence Theorem
• The proposition that an increase in the government
budget deficit has no effect on aggregate demand
13-21
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Possible Offsets to Fiscal Policy
(cont'd)
• Planning for the future:
The Ricardian equivalence theorem
– The reason for the offset
• People anticipate that a larger deficit today will mean
higher taxes in the future and adjust their spending
accordingly.
13-22
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Possible Offsets to Fiscal Policy
(cont'd)
• Direct Expenditure Offsets
– Actions on the part of the private sector in
spending income that offset government fiscal
policy actions
– Any increase in government spending in an area
that competes with the private sector will have
some direct expenditure offset.
13-23
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Possible Offsets to Fiscal Policy
(cont'd)
• The supply-side effects of changes in taxes
– Expansionary fiscal policy could involve reducing
marginal tax rates.
• Advocates argue this increases productivity since
individuals will work harder and longer, save more, and
invest more.
• The increased productivity will lead to more economic
growth.
13-24
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Possible Offsets to Fiscal Policy
(cont'd)
• Supply-Side Economics
– The suggestion that creating incentives for
individuals and firms to increase productivity will
cause the aggregate supply curve to shift
outward
13-25
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Possible Offsets to Fiscal Policy
(cont'd)
• Question
– Would a tax increase cause you to work more or
less?
13-26
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Figure 13-5 Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together
13-27
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Policy Example: A Laffer Curve in
the Mid-2000s?
• In 2003 Congress reduced the top tax rate
on corporate dividends and the tax rate on
capital gains along with cutting personal
income tax rates slightly.
• Many critics predicted that the federal
government’s tax revenues would plummet
after these rates were cut.
13-28
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Policy Example: A Laffer Curve in
the Mid-2000s? (cont'd)
• By the middle of 2008, after five years of
higher real GDP growth, total federal
income tax receipts from corporations and
individuals had increased by nearly 50%.
• Why do you suppose it is difficult to
determine exactly which factors are most
responsible for the increase?
13-29
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Discretionary Fiscal Policy in
Practice: Coping with Time Lags
• Question
– Is fiscal policy as precise as it appears?
13-30
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Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
– Recognition Time Lag
• The time required to gather information about the
current state of the economy
13-31
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Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
– Action Time Lag
• The time required between recognizing an economic
problem and putting policy into effect
– Particularly long for fiscal policy which requires
congressional approval
13-32
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Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
– Effect Time Lag
• The time it takes for a fiscal policy to affect the
economy
13-33
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Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Fiscal policy time lags are:
– Long – a policy designed to correct a recession
may not produce results until the economy is
experiencing inflation.
– Variable in length – they can be from 1-3
years, and the timing of the desired effect
cannot be predicted.
• Because fiscal policy time lags tend to be
variable, policymakers have a difficult time
fine-tuning the economy.
13-34
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Automatic Stabilizers
• Automatic or Built-In Stabilizers
– Changes in government spending and taxation
that occur automatically without deliberate
action of Congress
• The tax system
• Unemployment compensation
• Welfare spending
13-35
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Automatic Stabilizers (cont’d)
• The Tax System
– Incomes and profits fall when business activity
slows down, and the government’s tax revenues
drop as well.
– Some economists consider this an automatic tax
cut, which therefore stimulates aggregate
demand.
13-36
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Automatic Stabilizers (cont’d)
• Unemployment Compensation and Income
Transfer Payments
– Unemployment compensation reduces changes in
people’s disposable income. Their disposable
income remains positive, although at a lower
level.
– In a recession, more people are eligible for
income transfer payments and do not experience
as dramatic a drop in disposable income.
13-37
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Automatic Stabilizers (cont’d)
• Stabilizing Impact
– The key impact of these systems is the ability to
mitigate changes in disposable income,
consumption, and the equilibrium level of GDP.
– If disposable income is prevented from falling as
much as it otherwise would in a recession, the
downturn will be moderated.
13-38
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Figure 13-6 Automatic Stabilizers
The automatic changes
tend to drive the economy
back toward its fullemployment output level
13-39
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What Do We Really Know About
Fiscal Policy?
• Fiscal policy during normal times
– Congress ends up doing too little too late to help
in a minor recession.
– Fiscal policy that generates repeated tax
changes (as has happened) creates uncertainty.
13-40
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What Do We Really Know About
Fiscal Policy? (cont'd)
• Fiscal policy during abnormal times
– Fiscal policy can be effective
• The Great Depression—fiscal policy may be able to
stimulate aggregate demand.
• Wartime—during World War II real GDP increased
dramatically.
13-41
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What Do We Really Know About
Fiscal Policy? (cont'd)
• The “soothing” effect of Keynesian fiscal
policy
– Should we encounter a severe downturn, fiscal
policy is available.
• Knowing this may reassure consumers and investors.
– Stable expectations encourage a smoothing of investment
spending.
13-42
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Issues and Applications: Does Government
Spending Crowd Out Private Health Care
Expenditures?
• Since the mid-1960s, the federal government has
directed an increasing share of tax dollars to
expenditures on health care services for U.S.
residents.
• The government’s spending on Medicare is nearly
$500 billion per year, or about 20% of total—
combined public and private—health care spending.
• Much of the recent growth in federal health care
spending, however, has occurred through
expansions of Medicaid and the State Children’s
Health Insurance Program.
13-43
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Issues and Applications: Does Government
Spending Crowd Out Private Health Care
Expenditures? (cont'd)
• Congress typically says that expanding
health care spending will provide health
care for U.S. residents who otherwise would
be privately uninsured and unable to pay for
services from their own resources.
• There is evidence that government health
care expenditures crowd out a significant
share of health care spending that
otherwise would be undertaken from private
funds.
13-44
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Issues and Applications: Does Government
Spending Crowd Out Private Health Care
Expenditures? (cont'd)
• Studies conducted by Gruber and Simon
estimate that new government coverage of
health care spending reduced private
provisions for health care expenditures by
about 60%.
• Based on Gruber and Simon’s estimate, has
the expansion of government health care
spending succeeded in covering some
people who otherwise might not have had
coverage of health care expenses?
13-45
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Summary Discussion of Learning
Objectives
• The effects of discretionary fiscal policy
using traditional Keynesian analysis
– Increases in government spending and
decreases in taxes increase aggregate demand.
– Decreases in government spending and
increases in taxes decrease aggregate demand.
13-46
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Summary Discussion of Learning
Objectives (cont'd)
• How indirect crowding out and direct
expenditure offsets can reduce the
effectiveness of fiscal policy actions
– Deficits increase interest rates.
– Some government spending replaces private
spending.
• If the Ricardian equivalence theorem is
valid, a tax cut has no effect on total
planned expenditures and aggregate
demand.
13-47
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Summary Discussion of Learning
Objectives (cont'd)
• Fiscal policy time lags and the effectiveness
of fiscal “fine tuning”
– The time lags for fiscal policy are the recognition
time lag, action time lag, and the effect time lag.
– The time lags are long and variable.
• Automatic stabilizers are changes in tax
payments, unemployment compensation,
and welfare payments that automatically
change with the level of economic activity.
13-48
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Figure C-1 The Impact of Higher Government
Spending on Aggregate Demand
13-49
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Figure C-2 The Impact of Higher Taxes
on Aggregate Demand
13-50
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