Spending Plan – formal or informal
• Types of budgets:
1. Balanced: Expenditures = Revenues
2. Surplus:
3. Deficit:
Expenditures < Revenues
Expenditures > Revenues
How the Federal Government Spends
Defense
Social Security
19%
Net Interest
22%
6%
Transportation
3.1%
15.5%
10.4%
24%
Other
Income Security
Medicare and health
A breakdown of the government expenditures
at the federal level.
Federal Government Spending
•
(Source: Economic Report of the President, Tables B-2 and B-22,
http://www.gpo.gov/fdsys/pkg/ERP-2014/content-detail.html)
How State & Local Governments Spend
Insurance trusts
Public welfare
& Health
7.7%
Education
32.2%
22.3%
7.9%
Police &
Fire Protection
12.2%
6.3%
7.1%
4.3%
Transportation
Utilities &
liquor stores
Interest on debt
Administration
& other
State and Local Government Spending
Spending by state and local government increased from
about 10% of GDP in the early 1960s to 14–16% by the
mid-1970s.
The single biggest spending item is education.
Source: (Source: Bureau of Economic Analysis.)
State & local taxes:
Federal taxes:
Property
15%
Payroll
34%
Payroll
12%
Personal
income
46%
Other
3%
Customs
duties 1%
Corporate
income
12%
User charges a
24%
Excise taxes
4%
Sales and
excise
17%
Personal
income
10%
From
federal
government
16%
Other
4%
1997
Corporate
income
2%
Taxes vary by state1994
FL. MI, NH,
TN Government
(?) – no Income Tax
How
Taxes:
NH motto: Live free or die...
but they have a tax on parachute jumps
Federal Tax Receipts
Federal tax revenues have been about 17–20% of GDP
during most periods in recent decades
(Source: Economic Report of the President, 2015. Table B-21,
https://www.whitehouse.gov/administration/eop/cea/economic-report-ofthe-President/2015)
Taxes!!!!!
A. Types of Taxes
or how the tax changes with income changes
 Progressive
tax is one in which the average
tax rate rises with income.
- tax brackets, Federal Income Tax
 Proportional tax is one in which the average
tax rate stays the same across income levels.
- flat tax, Social Security, Medicare,
sales tax?
 Regressive tax is one in which the average
tax rate falls with income.
- sales tax – higher income spend
lower proportion on taxable goods
•
•
•
•
•
•
•
A sales tax of 7 % on medicine
A state income tax with 3 tax brackets
A property tax of $2.85 per $100 of
assessed property value
A tax of $8 on room occupancy in all city
hotels
A tax of 3 % on all wages earned in the city
A sales tax of 5% on utilities
A federal tax of $2 per pack of cigarettes.
Expenditures > Revenue
Expenditures < Revenues
Discretionary changes in
taxes and/or spending
affect the Budget
Debt/GDP Ratio
Annual deficits do not always mean that the debt/GDP ratio is rising.
During the 1960s and 1970s, the government often ran small deficits,
so the debt/GDP ratio was declining over this time.
In the 2008–2009 recession, the debt/GDP ratio rose sharply.
(Source: Economic Report of the President, Table B-20, http://www.gpo.gov/fdsys/pkg/ERP2015/content-detail.html)
2003
2004
2005
2006
2007
2008
2009
2010 (estimate)
2011 (estimate)
2012 (estimate)
-377
-413
-318
-248
-161
-459
-1413
-1556
-1267
-829
1. Generally small deficits except during
recessions.
2. Budget deficits generally increased during
recessions and shrank during expansions,
(automatic stabilizers, not discretionary policy)
3. Reductions in income tax rates and sharp
increases in defense expenditures led to large
deficits during the 1980s.
4. The deficits replaced by surpluses in the 1990s.
5. Real economic growth was strong and the
inflation rate low during 80s and 90s
6. The combination of:
-the 2001 recession
-the economy’s sluggish recovery
-the Bush Administration’s tax cut, and
-increases in defense spending
quickly moved the budget from surplus to
deficit at the beginning of the new century.
Federal Expenditures and Revenues
Federal Government Expenditures and Revenues (as a share of GDP)
24%
Expenditures
22%
20%
Surplus
Deficits
18%
Revenues
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
• Note the growth of budget deficits during the
1980s and the movement to surpluses during
the 1990s.
• Since 2002, the deficits have been sizeable and
they soared to peacetime highs during the
recession of 2008-2009.
Growth of Real Federal Government
and Defense Expenditures
Percent
rate of change
8%
6%
Total
4%
2%
0%
Defense
-2%
-4%
1980
1985
1990
1995
2000
• During the 1980s, rapid growth of defense spending pushed federal
spending upward and contributed substantially to the large deficits of the
decade.
• During the 1990s, defense cuts retarded the growth of federal
spending and thereby helped shift the budget to surplus.
Fiscal Policy & Economic Performance:
• In the 1960s, most economists believed fiscal
policy was highly potent and could be used to
smooth out the business cycle.
• Confidence in the ability of policy makers to
implement countercyclical fiscal policy has waned.
• Most now believe that fiscal policy exerts only a
modest impact on aggregate demand, much like
the crowding-out and new classical models imply.
• Since 1980, real growth has been strong during
periods of both expanding (1980s and 2002-2006)
and contracting (1990s) deficits.
Price
Level
market selfadjustment
may be a lengthy
process.
LRAS
SRAS1
SRAS2
E2
P2
P1
e1
P3
E3
directs the
Economy to
full-employment
AD1 AD2
Y 1 YF
Goods & Services
(real GDP)
• Equilibrium below full employment. Two options
1. Wait for SRAS1 to shift out to SRAS2
2. Shift AD1 out to AD2
Expansionary Fiscal Policy
This graph shows that since the economy was originally
producing below potential GDP, any inflationary
increase in the price level from P0 to P1 that results
should be relatively small.
Price
Level
SRAS2
LRAS
SRAS1
P3
E3
P1
P2
e1
E2
restrains demand and
helps control inflation.
AD2 AD1
YF Y 1
Goods & Services
(real GDP)
• Equilibrium above full employment at Y1.
1. Will lead to the long-run equilibrium E3 at a
higher price level as SRAS shifts to SRAS2. or
2. Reduce demand to AD2 and lead to equilibrium E2.
Contractionary Fiscal Policy
The economy starts
above potential GDP.
The extremely high
level of aggregate
demand will generate
inflationary increases in
the price level.
A contractionary fiscal policy can shift aggregate demand down
from AD0 to AD1, leading to a new equilibrium output E1, which
occurs at potential GDP, where AD1 intersects the LRAS curve.
There is a larger effect on the Price level with this case
Decline in
private investment
Increase in
budget deficit
Higher real
interest rates
Inflow of financial
capital from abroad
Appreciation
of the dollar
Decline in
net exports
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
1. Equilibrium at E0
2. AD decreases to AD1 and output falls to Y1
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD2
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
3. While policy is being enacted, private investment
has begun to recover.
4. AD has begun shifting back to AD0 on its own, the
effects of fiscal policy over-shift AD to AD2.
Price
Level
LRAS
SRAS2
SRAS1
P3
E3
P2
e2
P0
P1
E0
e1
AD2
AD0
AD1
Y1 Y0 Y2
Goods & Services
(real GDP)
• The price level in the economy rises (from P1 to P2) as
the economy is now overheating.
• Unless the expansionary fiscal policy is reversed, wages
and other resource prices will eventually increase,
shifting SRAS back to SRAS2 (driving the price level up
to P3).
Price
Level
LRAS
SRAS1
P2
P0
e2
E0
AD2
AD0
Y0 Y2
Goods & Services
(real GDP)
1. Demand shifts AD out to AD2, and prices upward to P2.
2. Restrictive Fiscal Policy is considered
Price
Level
LRAS
SRAS1
P2
e2
P0
P1
E0
e1
AD2
AD0
AD1
Y1 Y0 Y2
Goods & Services
(real GDP)
2. The price level falls (from P2 to P1) as the
economy is thrown into a recession.
3. With the timing lag, fiscal policy does not work
instantaneously.
Price
Level
LRAS
SRAS1
P2
P0
e2
Suppose that shifts in AD
are difficult to forecast.
E0
AD2
AD0
AD1
Y0 Y2
Goods & Services
(real GDP)
4. Investment returns to its normal rate
(shifting AD2 back to AD0).
5. The effects of fiscal policy over-shift AD to AD1.
Price
Level
SRAS1
G
H
G
P1
AD1
Y1
AD2
Goods & Services
(real GDP)
• Government deficit would shift AD1 to AD2.
• Household saving keeps demand unchanged at AD1.
Loanable Funds
Market
Real
interest
rate
S1
S2
e1
no effect on the interest
rate, real GDP,
and unemployment.
e2
r1
D1
Q1
Q2
D2
Quantity of
loanable funds
1. Government borrows from the loanable funds
market, increasing the demand (to D2).
2. People save for expected higher future taxes
(raising the supply of loanable funds to S2.)
3. Loans increase, but interest rate doesn’t.
Price
Level
LRAS1 LRAS2
SRAS1
SRAS2
P0
E1
E2
AD1
YF1
YF2
With time, lower tax rates
promote more rapid growth
(shifting LRAS and SRAS
out to LRAS2 and SRAS2).
AD2
Goods & Services
(real GDP)
1. Lower marginal tax rates shifts AD1 out to AD2,
and SRAS & LRAS shift to the right.
2. If the tax cuts are financed by budget deficits, AD
may expand by more than supply, bringing an
increase in the price level.
Share of personal income taxes
paid by top ½ % of earners
30 %
28 %
26 %
24 %
22 %
20 %
1964-65
Top rate cut from
91% to 70%
2001-2004
Top rate cut from
39.6% to 35%
1990-93
Top rate raised from
30% to 39.6%
1986
Top rate cut from
50% to 30%
1997
Capital gains
tax rate cut
18 %
1981
Top rate cut from
70% to 50%
16 %
14 %
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
• Their share of taxes paid has increased as the top
tax rates have declined.
• This indicates that the supply side effects are
strong for these taxpayers.
O
b
a
m
a
“Soaking the Rich?”
• Since 1986 the top tax rate has been less
than 40% .
• The top one-half percent of earners have
paid more than 25% of the personal income
tax every year since 1997.
• Well above the 14% to 19% from the 1960s
and 1970s.
1. If an economy operates in the short run
at point a, restrictive fiscal policy will
a. increase AD and move the economy toward point c.
b. decrease AD and move the economy toward point b.
c. increase SRAS and move the economy toward point b.
d. decrease SRAS and move the economy toward point c.
2. When the economy is operating at point a, reliance
on the self-correcting mechanism will
a. result in higher resource prices and a shift to the left in the SRAS curve.
b. result in lower resource prices and a shift to the right in the SRAS curve.
c. lead to lower interest rates and a shift to the right in the AD curve.
d. lead to higher interest rates and a shift to the left in the AD curve.
e. do both a and d.
3. Which of the following will a Keynesian most likely favor if the economy is
operating at point a?
a. a tax cut
b. an increase in government expenditures
c. restrictive fiscal policy
d. an increase in the budget deficit
4. If the output of the economy is Y1,
which of the following would a Keynesian
economist be most likely to favor?
a. a reduction in government expenditures
b. an increase in government expenditures
c. an increase in taxes
d. continuation of the current tax and
expenditure policies
5. If the output of the economy is Y1, which of the following would a new
classical economist be most likely to favor?
a. a reduction in government expenditures
b. a reduction in taxes
c. an increase in taxes
d. continuation of the current tax and expenditure policies
6.
When government expenditures exceed
revenue from all sources,
a.
a budget deficit is present.
b.
the supply of money will increase.
c.
the government’s outstanding debt will
decline.
d.
all of the above are true.
7.
According to the Keynesian view, which of
the following would most likely decrease aggregate
demand?
a.
a decrease in tax rates
b.
a decrease in government expenditures
c.
an increase in transfer payments
d.
an increase in the budget deficit