Fiscal Policy

1 of 25Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.

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Fiscal Policy

FERNANDO QUIJANO, YVONN QUIJANO,

AND XIAO XUAN XU

P R E P A R E D B Y

The conventional wisdom among both politicians and economic policymakers for years was that active use by the government of changes in spending and taxes could play only a limited role in fighting recessions.

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A P P L Y I N G T H E C O N C E P T S

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2

Why are the United States and many other countries facing dramatically increasing costs for their government programs?

Increasing Life Expectancy and Aging PopulationsSpur Costs of Entitlement Programs

How are tax rates and tax revenues related?The Confucius Curve?

Did the 2001 tax cuts stimulate consumer spending?Were the 2001 Tax Cuts Spent or Saved?

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. Fiscal Policy

● fiscal policyChanges in government taxes and spending that affect the level of GDP.

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. THE ROLE OF FISCAL POLICY10.1Fiscal Policy and Aggregate Demand

FIGURE 10.1Fiscal Policy in ActionPanel A shows that an increase in government spending shifts the aggregate demand curve from AD0 to AD1, restoring the economy to full employment. This is an example of expansionary policy.

Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD0 to

AD1, restoring the economy to full employment. This is an example of contractionary policy.

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. THE ROLE OF FISCAL POLICY10.1

Fiscal Policy and Aggregate Demand

● expansionary policiesGovernment policy actions that lead to increases in aggregate demand.

● contractionary policiesGovernment policy actions that lead to decreases in aggregate demand.

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The Fiscal Multiplier

● stabilization policiesPolicy actions taken to move the economy closer to full employment or potential output.

The Limits to Stabilization Policy

As the government develops policies to stabilize the economy, it needs to take the multiplier into account. The total shift in aggregate demand will be larger than the initial shift. As we will see later in this chapter, U.S. policymakers have taken the multiplier into account as they have developed policies for the economy.

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. THE ROLE OF FISCAL POLICY10.1The Limits to Stabilization Policy

LAGS

FIGURE 10.2Possible Pitfalls in Stabilization PolicyPanel A shows an example of successful stabilization policy. The solid line represents the behavior of GDP in the absence of policies. The dashed line shows the behavior of GDP when policies are in place. Successfully timed policies help smooth out economic fluctuations.Panel B shows the consequences of ill-timed policies. Again, the solid line shows GDP in the absence of policies and the dashed line shows GDP with policies in place. Notice how ill-timed policies make economic fluctuations greater.

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The Limits to Stabilization Policy

LAGS

● inside lagsThe time it takes to formulate a policy.

● outside lagsThe time it takes for the policy to actually work.

FORECASTING UNCERTAINTIES

What makes the problem of lags even worse is that economists are not very accurate in forecasting what will happen in the economy.

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. THE FEDERAL BUDGET10.2

Federal Spending

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Federal Spending

● discretionary spendingThe spending programs that Congress authorizes on an annual basis.

● entitlement and mandatory spendingSpending that Congress has authorized by prior law, primarily providing support for individuals.

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Federal Spending

● Social SecurityA federal government program to provide retirement support and a host of other benefits.

● MedicareA federal government health program for the elderly.

● MedicaidA federal and state government health program for the poor.

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• Today, Social Security, Medicare, and Medicaid constitute approximately 9 percent of GDP.

• Experts estimate that in 2075 spending on these programs will be approximately 21 percent of GDP.

How will our society cope with increased demands for these services?

Possible solutions:

• Leave the existing programs in place and just raise taxes to pay for them.

• The government should save and invest now to increase GDP in the future to reduce the burden on future generations.

• Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being.

• Reform the health-care system to encourage more competition to reduce health-care expenditures.

INCREASING LIFE EXPECTANCY AND AGING POPULATIONSSPUR COSTS OF ENTITLEMENT PROGRAMS

APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing

costs for their government programs?

A P P L I C A T I O N 1

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Federal Revenues

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Federal Revenues

● supply-side economicsA school of thought that emphasizes the role that taxes play in the supply of output in the economy.

● Laffer curveA relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged.

SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE

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While the idea that cutting tax rates might actuallyincrease tax revenue is often attributed to economistArthur Laffer, in fact, it is actually a much older ideathan that.

Yu Juo, one of the twelve wise men who succeeded Confucius in ancient China, was asked what should be done in the case of a famine if the government had insufficient funds. He replied that the tax rate should be cut to 10 percent. Skeptical government bureaucrats did not have enough funds at a 20 percent rate, so how could they cut it to 10 percent?

Yu Juo replied, “Cutting taxes and limiting your expenses allow people to raise their standard of living. Afterwards, you will no longer need to worry about famine and shortage.”

Revenue estimators in Washington, D.C, do not share entirely in Yu Juo’s wisdom, but they do recognize that cutting tax rates will stimulate economic activity.

THE CONFUCIUS CURVE?APPLYING THE CONCEPTS #2: How are tax rates and tax

revenues related?


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The Federal Deficit and Fiscal Policy

● budget deficitThe amount by which government spending exceeds revenues in a given year.

● budget surplusThe amount by which government revenues exceed government expenditures in a given year.

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Automatic Stabilizers

● automatic stabilizersTaxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action.

The increased federal budget deficit works through three channels:

1 Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income.

2 Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much.

3 Because the corporation tax depends on corporate profits and profits fall in a recession, taxes on businesses also fall. Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession.

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Are Deficits Bad?

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. FISCAL POLICY IN U.S. HISTORY10.3

The Depression Era

The Kennedy Administration

During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits. According to Brown, fiscal policy was expansionary only during two years of the Great Depression, 1931 and 1936.

Although modern fiscal policy was not deliberately used during the 1930s, the growth in military spending at the onset of World War II in 1941 increased total demand in the economy and helped pull the economy out of its long decade of poor performance. But to see fiscal policy in action, we need to turn to the 1960s. It was not until the presidency of John F. Kennedy during the early 1960s that modern fiscal policy came to be accepted.

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The Vietnam War Era

● permanent incomeAn estimate of a household’s long-run average level of income.

The Reagan Administration

The tax cuts enacted during 1981 at the beginning of the first term of President Ronald Reagan were significant. However, they were not proposed to increase aggregate demand. Instead, the tax cuts were justified on the basis of improving economic incentives and increasing the supply of output.

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The Clinton and George W. Bush Administrations

FIGURE 10.3Federal Taxes, Spending, and Deficits, 1996–2006

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According to conventional economic theory, a permanent cut in taxes should largely be spent by households because it represents a new permanent source of income for them.

WERE THE 2001 TAX CUTS SPENT OR SAVED?APPLYING THE CONCEPTS #3: Did the 2001 tax cuts

stimulate consumer spending?

To discover whether households actually spent the tax cuts, professors Matthew Shapiro and Joel Slemrod decided to ask some of them.

• Result: Fewer than 25 percent of households were likely to spend the rebate. Moreover, low-income households were no more likely to spend the rebate than higher-income households.

These survey results may not reflect the actual behavior of consumers. The Congressional Budget Office reviewed other studies that directly examined consumer spending after the rebates.

• Result: Financially strapped households do spend any tax cuts they receive.


In 2001, approximately 90 million U.S. households received tax rebate checks from the government.

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automatic stabilizers

budget deficit

budget surplus

contractionary policies

discretionary spending

entitlement and mandatory spending

expansionary policies

fiscal policy

inside lags

Laffer curve

Medicaid

Medicare

outside lags

permanent income

Social Security

stabilization policies

supply-side economics

K E Y T E R M S

Fiscal Policy

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