Chapter 12 Fiscal Policy
Budget Deficits and Surpluses • Budget deficit:-- Present when total government spending exceeds total revenue from all sources. • When the money supply is constant, deficits must be covered with borrowing. • The U.S. Treasury borrows funds by issuing bonds. • Budget surplus:-- Present when total government spending exceeds total revenue from all sources. • Surpluses reduce the size of the government’s outstanding debt.
Budget Deficits and Surpluses • Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is adding additional demand stimulus or imposing additional demand restraint. • Changes in the size of the budget deficit or surplus may arise from either: • A change in the state of the economy, or, • A change in discretionary fiscal policy--that is, through either government spending and/or changes in taxation.
The Keynesian View of Fiscal Policy • Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in demand. • When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy -- it should either: • increase the government’s purchases of goods & services, and/or, • cut taxes.
Price level LRAS SRAS1 SRAS3 E2 Expansionary fiscal policy stimulates demand and directs the economy to full-employment e1 P P P 3 2 1 E3 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. AD2 AD1 Goods &Services(real GDP) Y Y Y Y Y F 1 F F F Expansionary Fiscal Policy to Promote Full-Employment • We begin in the short run at Y1, below the economy’s potential capacity (YF). There are 2 routes to long-run full-employment equilibrium. • Policymakers could wait for both lower wages and resource prices to reduce costs, increase supply to SRAS3 and restore equilibrium at YF. • Alternatively, expansionary fiscal policy could stimulate aggregate demand (shift AD1 to AD2) and guide the economy back to E2, at YF.
The Keynesian View of Fiscal Policy • When inflation is a potential problem, the Keynesian analysis suggests a shift toward a more restrictive fiscal policy: • reduce government spending, and/or, • raise taxes. • Keynesians challenged the view that the government’s should always be balance its budget. • Rather than balancing the budget annually, Keynesians argued that counter-cyclical policy should be used to offset fluctuations in aggregate demand.
Price level LRAS SRAS3 SRAS1 E3 Restrictive fiscal policy restrains demand and helps control inflation. P P P e1 1 3 2 E2 AD1 AD2 Goods &Services(real GDP) Y Y Y Y F F 1 F Restrictive Fiscal Policy to Combat Inflation • Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential (YF). • If maintained, the high level of demand will lead to the long-run equilibrium E3 at a higher price level (as SRAS shifts back to SRAS3). • However, restrictive fiscal policy could restrain demand from expanding to AD2 in the first place and guide the economy to a non-inflationary equilibrium (E2).
Fiscal Policy and the Crowding-out Effect • The Crowding-out Effect:-- indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy. • The implications of the crowding-out analysis are symmetrical. • Restrictive fiscal policy will reduce real interest rates and "crowd in" private spending. • Crowding-out Effect in an open economy: -- Larger budget deficits and higher real interest rates also lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.
Decline inPrivate Investment Increase In Budget Deficit Higher RealInterest Rates Inflow of Financial Capital from Abroad Appreciation of the Dollar Decline in Net Exports A Visual Presentation of the Crowding-Out Effect in an Open Economy • An increase in govt. borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. • This retards private investmentand thereby Aggregate Demand. • In an open economy, higher interest rates attract capital from abroad. • As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. • In turn, the appreciation of the dollar causes net exports to fall. • Thus, as a result of increased budget deficits, higher interest rates trigger reductions in both private investment and net exports, which weaken the expansionary impact of a budget deficit.
The New Classical View of Fiscal Policy • The New classical view stresses that: • debt financing merely substitutes higher future taxes for lower current taxes, and thus, • budget deficits affect the timing of taxes, but not their magnitude. • New Classics argue that when debt is substituted for taxes • people will save the increased income so they will be able to pay the higher future taxes, thus, • the budget deficit does not stimulate aggregate demand.
The New Classical View of Fiscal Policy • Similarly, the real interest rate is unaffected by deficits since people will save more in order to pay the higher future taxes. • According to the new classical view, fiscal policy is completely impotent. It does not effect output, employment, or real interest rates.
Price level SRAS1 P 1 AD2 AD1 Goods &Services(real GDP) Y 1 New Classical View -- Higher Expected Future Taxes Crowd-out Private Spending • New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes. • If households did not anticipate the higher future taxes, aggregate demand would increase (from AD1to AD2). • However, demand remains unchanged at AD1 when households fully anticipate the future increase in taxes and, so, save for them.
Price level S1 S2 Under this model, fiscalpolicy exerts no effect -- the interest rate, real GDP, and level of unemploymenteach remain unchanged. r r e2 e1 1 1 D2 D1 Loanable Funds Q Q 1 2 New Classical View -- Higher Expected Future Taxes Crowd-out Private Spending • In order to finance the budget deficit, the govt borrows from the loanable funds market, increasing the demand (from D1 to D2). • According to the new classical view, people will save more in order to pay the higher future taxes implied by the increases in debt. This will increase the supply of loanable funds to S2. • This permits the government to borrow the funds to finance the deficit without pushing up the interest rate.
Fiscal Policy: -- Problems with Proper Timing • Various time lags make proper timing of changes in discretionary fiscal policy difficult. • Discretionary fiscal policy is like a two-edged sword; it can both harm and help. • If timed correctly, it may reduce economic instability. • If timed incorrectly, however, it may increase economic instability.
Price level LRAS SRAS Consider that shifts in AD are difficult to forecast. e1 P P 1 0 E0 AD0 AD1 Goods &Services(real GDP) Y Y Y F F 1 Why Proper Timing of Fiscal Policy is Difficult • We begin long-run equilibrium (E0) at the price level P0 and output Y0. At this output, only the natural rate of unemployment is present. • An investment slump and business pessimism result in an unanticipated decline in AD (to AD1). Output falls and unemployment increases. • After a time, policymakers institute expansionary fiscal policy seeking to shift AD back to AD0, but by the time fiscal policy begins to exert its primary effect, private investment has recovered and decision makers have become increasingly optimistic about the future.
SRAS2 LRAS e4 e2 e1 P P P P 0 3 1 2 E0 AD2 AD0 AD0 Y Y Y Y 2 F 1 F Why Proper Timing of Fiscal Policy is Difficult Price level SRAS AD1 Goods &Services(real GDP) • Thus, just as AD begins shifting back to AD0 by its own means, the effects of fiscal policy over-shift AD to AD2. • The price level in the economy rises as the economy is now overheated. • 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 SRAS e2 P P E0 0 2 E0 AD2 AD0 AD0 Goods &Services(real GDP) Y Y Y 2 F F Why Proper Timing of Fiscal Policy is Difficult • Alternatively, suppose an investment boom disrupts the initial equilibrium shifting aggregate demand out to AD2, placing upward pressure on prices. • Policymakers respond by increasing taxes and cutting government expenditures, but by the time that the restrictive fiscal policy has had an opportunity to take effect, investment returns to its normal rate (shifting AD2 back to AD0).
LRAS e2 e1 P P P 1 2 0 E0 E0 AD0 AD1 Y Y Y Y F 2 F 1 Why Proper Timing of Fiscal Policy is Difficult Price level SRAS AD2 AD0 Goods &Services(real GDP) • Thus, just as AD begins shifting back to AD0 by its own means, the effects of fiscal policy over-shift AD to AD1. • The price level in the economy falls as the economy is now thrown into recession. • Because fiscal policy does not work instantaneously, and since dynamic factors are constantly influencing private demand, proper timing of fiscal policy is not an easy task.
Fiscal Policy: -- Problems with Proper Timing • Automatic Stabilizers: -- without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. • Examples of Automatic Stabilizers: • Unemployment Compensation • Corporate Profit Tax • A Progressive Income Tax
Fiscal Policy as a Tool: -- A Modern Synthesis • The proper timing of discretionary fiscal policy is both difficult to achieve and of crucial importance. • Automatic stabilizers reduce the fluctuation of aggregate demand and help to direct the economy toward full-employment. • Fiscal policy is much less potent than the early Keynesian view implied.
1. What is the Keynesian view of fiscal policy? How do the crowding-out and new classical models modify the basic Keynesian analysis? Questions for Thought: 2. Why is the proper timing of a change in fiscal policy important? 3. "Budget deficits may stimulate aggregate demand and output in the short run, but since they divert funds away from capital formation and toward current consumption, they will retard the growth of output in the long run." Do you agree with this statement?
Supply-side Effects of Fiscal Policy • From a supply-side viewpoint, the marginal tax rate is of crucial importance: • A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less heavily taxed. • High marginal tax rates will tend to retard total output because they will: • Discourage work effort and reduce the productive efficiency of labor, • Adversely affect the rate of capital formation and the efficiency of its use, and, • Encourage individuals to substitute less desired tax-deductible goods for more desired non-deductible goods.
Supply-side Effects of Fiscal Policy • Thus, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance. • Impact of supply-side effects • Are likely to take place over a lengthy time period. • There is some evidence that countries with high taxes grow more slowly—France and Germany versus United Kingdom. • While the significance of supply-side effects are controversial, there is evidence they are important for taxpayers facing extremely high rate, say rates of 40 percent and above.
Price level LRAS1 LRAS2 SRAS1 SRAS2 With time, lower tax rateswill promote more rapidgrowth (shifting LRASand SRAS to the right to LRAS2 and SRAS2). E1 P P 0 0 E2 AD2 AD1 Goods &Services(real GDP) Y Y F2 F1 Tax Rate Effects and Supply-Side Economics • What are the supply-side effects of a reduction in marginal tax rates? • The lower marginal tax rates increase the incentive to earn and use resources efficiently. AD1shifts out to AD2, and as the effects of the tax cut are long-run as well as short-run, both SRASand LRAS shift out. • If the lower tax rates are financed by budget deficits, aggregate demand may expand by a larger amount than aggregate supply, leading to an increase in the price level.
Share of Personal Income TaxesPaid by Top 0.5Percent of Earners .23 1986 .22 1990–93 Top rate Top rate cut from raised from 50% to 30% .21 30% to 39.6% 1964–65 .20 Top rate cut from .19 91% to 70% This graphic illustrates that, at least for this group of high-income recipients, there existed strong supply-side effects associated with changes in marginal rates. .18 .17 .16 1981 .15 Top rate cut from 70% to 50% .14 < Year 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 How Have Changes in Marginal Tax Rates Affected the Share of Taxes Paid By The Rich? • The above graph indicates the share of the personal income tax paid by the top one-half percent of earners during 1960-1996. There were 3 major reductions in the top marginal tax rate during this period. • Note that the share of the tax bill paid by these “super-rich” earners increased following each of the tax cuts and fell when inflation pushed more and more taxpayers into higher tax brackets during the ‘70s and when rates were raised again (to 39.6%) during the Bush/Clinton years.
Percentof Real GDP 26 Expenditures 24 22 Deficits 20 Revenues 18 < 1980 1985 1990 1995 2000 1960 1965 1970 1975 Year Empirical Evidence on the Impact of Fiscal Policy • Fiscal policy during the past 4 decades: • Since 1960 the federal budget as a % of GDP has generally increased during recessions and declined during periods of economic expansion. • Budget deficits and interest rates: • The year-to-year relationship is weak. • However, interest rates were high as the deficits of the early 80’s rose.
Component as a % of GDP Gross Investment Less Net Gross Federal Real Net Foreign Time Net Private Interest Deficit Foreign Personal Investment Period Rate Exports Investment A Investment % Of GDP Consumption 17.5 17.5 2.9 1.9 62.3 0.0 - 0.8 16.7 14.1 5.1 7.5 65.0 2.6 - 2.6 1976–1980 -0.8 -3.4 +2.2 +5.6 +2.2 +2.6 -1.8 1983–1987 15.7 16.2 0.9 2.4 62.0 - 0.5 0.2 15.3 13.7 4.0 6.1 65.8 1.6 - 1.6 1960–1974 -0.4 +2.5 +3.1 +3.7 +3.8 +2.1 -1.8 1981–1994 B D ifferential B Differential A B The real interest rate was derived by subtracting Later period minus earlier period. As the data of thefirst column indicate, the federal deficits were larger the annual inflation rate as measured by the GDP deflator from the AAA corporate bond rate. during the later period. Source: Derived from the Economic Reportof the President, 1996, Tables B-1, B-3, B-28, and B-73. Empirical Evidence on the Impact of Fiscal Policy • Consumption and Investment: • As deficits rose from ‘83 to ‘87, consumption rose (from 62.2% to 65%), consequently savings fell (also in ‘81-‘84 period). • This runs contrary to the new classical view. • Appreciation of the dollar, capital inflow and net exports: • As deficits rose from ‘83 to ‘87, net foreign investment rose (from 0% to 2.6%), while net exports fell. (also in ‘81-‘84 period). • This is consistent with the crowding-out model.
Current View of Fiscal Policy • Compared to two decades ago, there is now greater awareness of the political and economic factors that make the proper timing of fiscal policy difficult. • There is now more concern about the impact of budget deficits on interest rates and capital formation. • In the 1990s, there has been more emphasis on controlling the deficit and balancing the budget.
1. The following quotation was made in the mid-1980s by Paul Samuelson, perhaps the leading American Keynesian: “In the early stages of the Keynesian revolution, macro- economists emphasized fiscal policy as the most powerful and balanced remedy for demand management. Gradually, shortcomings of fiscal policy became apparent. The short- comings stem from timing, politics, macroeconomic theory, and the deficit itself." What are the shortcomings Samuelson is referring to? Questions for Thought: 2. Outline the supply-side view of fiscal policy. How does this view differ from the various demand-side theories? 3. The budget deficit decreased steadily during 1993-1998. What factors accounted for the reduction in the deficit during the period? Do you think a change in views toward fiscal policy played any role? Did the deficit reduction exert a positive or negative impact on the economy?