Fiscal Policy
Recall: Fiscal Policy- government’s choices regarding spending and
taxes.
Defn:The federal budget is an annual statement of the revenues,
outlays, and surplus or deficit of the gov.
Ques: What is meant by a balance budget?
National Debt is the sum of past budget deficits. (not to be mistaken
with the deficit itself)
Ex. National debt in 08= debt of 08 + deficit of 08.
n.B the fiscal year runs from Oct. 1- Sep. 30
Fiscal Policy and the Supply Side (Potential GDP)
Supply-side effects are the effects of fiscal policy on potential
GDP and aggregate supply.
Ex. The provision of public goods, labor market incentives (note:
reduction in income can create a supply side effect).
Recall How does a reduction in income taxes impact the labor
market, the full employment level, and potential GDP?
Defn: Tax wedge in the labor market is the gap between the
before-tax wage rate and the after-tax wage rate.
Recall the tax incidence from Econ151.
16.2 THE SUPPLY SIDE AND POTENTIAL GDP
The Effects of the Income
Tax
The income tax
1. Decreases the supply of
labor.
2. Creates a tax wedge
between the wage rate
that firms pay and workers
receive.
THE SUPPLY SIDE AND POTENTIAL GDP
Note: There are other forms of taxes
1) Income tax 2) consumption tax 3) capital gains tax (tax on
lending/interest rate tax)
These forms of tax add to the tax wedge, reducing potential GDP.
How does a tax on consumption impact potential GDP?
(hint: A tax on consumption is similar to a fall in real wage rate)
It reduces the incentive to provide labor.
The total tax wedge = income tax + consumption tax.
Ex. Tax on income is 15%, tax on consumption is 10%. What is the
total tax wedge? How much goods and services can $100 of
income buy?
(Assumption: The tax effects are all considered at once.)
Tax on Interest Income
Recall: real interest rate= nominal rate – inflation.
And the real interest rate determines the loanable funds market
(what is saved and invested)
Point: Capital gains tax are levied on nominal interest rate, savings
and investment decisions are made upon the real after tax int. rate.
Ex. Suppose interest income tax is 10%.
i)
Nominal interest rate = 30% and inflation = 5%
ii)
Nominal interest rate = 45% and inflation= 30%
What is the real after tax interest rate? What is the true tax rate?
(hint: true rate= tax paid/real interest rate)
Income Tax Revenues and the Laffer Curve
Laffer curve is the relationship between the tax rate and total tax
revenue. As the tax rate rises, tax revenues rise, reach a maximum,
and then fall.
THE SUPPLY SIDE AND POTENTIAL GDP
1. At a tax of t*, tax revenue
is maximized.
2. For tax rates below t*, an
increase in the tax rate
increases tax revenue.
For example, the United
States and United kingdom.
3. For tax rates above t*, an
increase in the tax rate
decreases tax revenue.
Perhaps France is an
example.
Ques 1.
The government cuts income taxes. Explain this
effect on the supply of labor, the demand for
labor, the equilibrium level of employment, and
potential GDP.
2.The government increases its outlays but
keeps tax revenue unchanged. Explain what
happens to savings, investment, the real interest
rate, and the growth rate of rgdp.
Demand Side Fiscal Policy
Discretionary fiscal policy is a fiscal policy action that is initiated
by an act of Congress.
For example
Automatic fiscal policy is a fiscal policy action that is triggered by
the state of the economy.
For example
Cyclical vs. Structural Deficit
Total Deficit = cyclical deficit + structural deficit
Cyclical deficit – the deficit brought about by automatic fiscal policy
Structural deficit- the deficit brought about by discretionary fiscal policy
( for example troubled asset relief program tarp)
Why is an increasing deficit and national debt bad?
1) Crowding out effect
2) Dollar devaluation (imports more expensive)
3) Possible higher future taxes
How should government stimulate the economy tax cuts or government
spending?
Multipliers
government expenditure multiplier: magnification effect of a
change in gov exp on A.D.
The tax multiplier is the magnification effect of a change in taxes
on aggregate demand.
n.b The magnitude of the tax multiplier is smaller than the
government expenditure multiplier.
The balanced budget multiplier is the magnification effect on a.d
of a simultaneous change in government expenditure and taxes
that leaves the budget balance unchanged. (Recall a balanced
budget)
Ques: is the balanced budget multiplier <,>, or = to zero?
Expansionary fiscal policy is a discretionary fiscal policy
designed to increase a.d.
Contractionary fiscal policy is a discretionary fiscal
policy designed to decrease A.D
Potential GDP is $10 trillion,
real GDP is $9 trillion, and
1. There is a $1 trillion
recessionary gap.
2. An increase in government
expenditure or a tax cut
increases expenditure by ∆E.
3. The multiplier increases
induced expenditure. The
AD curve shifts rightward to
AD1.
The price level rises to 110,
real GDP increases to $10
trillion, and the recessionary
gap is eliminated.
Potential GDP is $10 trillion,
real GDP is $11 trillion, and
1. There is a $1 trillion
inflationary gap.
2. A decrease in government
expenditure or a tax rise
decreases expenditure by ∆E.
3. The multiplier decreases
induced expenditure.
The AD curve shifts
leftward to AD1.
The price level falls to 110,
real GDP decreases to
$10 trillion, and the
inflationary gap is
eliminated.
Limitations of Discretionary Fiscal Policy
Law-Making Time Lag
The amount of time it takes Congress to pass the laws needed to
change taxes or spending.
Economic Forecasting
Fiscal policy changes take a long time to enact in Congress and yet
more time to become effective.
So fiscal policy must target forecasts of where the economy will be
in the future