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Lecture 4: Fiscal Policy Fiscal Policy Fiscal policy is the government's control over taxes and government spending in order to influence the overall economy (variables

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Lecture 4: Fiscal Policy

Fiscal Policy

Fiscal policy is the government's control over taxes and government spending in order to influence the overall economy (variables such as GDP, unemployment, and inflation). It is controlled by the President and Congress jointly. Generally, the President will propose a budget each year, Congress often comes up with their own budget, and then a compromise must be reached. Congress can pass their own budget, but the President can veto the budget. Fiscal policy generally looks at total taxes rather than individual taxes, such as a gas tax. Similarly with government spending, we focus more on total government spending rather than specific types of spending, such as military spending or education spending. There are times when the budget is more of the President's and times when it is more of a joint action between Congress and the President. For example, the 2017 tax cut of $1.4 trillion that primarily benefited the wealthy was a President Trump/Republican tax cut. On the other hand, the 2020 Covid stimulus package passed in March 2020 was more of a joint action between the Democratic House and President Trump.

As I go through government spending and taxes, I will first look at the short-term effects on the business cycle. I will then return to the long run problem of budget deficits.

Government Spending

We have seen that the main cause of a recession is that there is too low a level of spending in the economy. Total spending, made up of consumption, investment, government purchases, and net exports, is at too low of a level. Businesses are not producing more because they are not selling enough products.Businesses are also not hiring more workers. The way out of a recession is when total spending increases. When that occurs, businesses increase production and hire more workers.

Since the government is part of the total spending picture, one clear tool that the government has for influencing the economy is through government purchases. The government can help to get an economy out of a recession by increasing government purchases. This could be for military spending, or education spending, or construction spending.This will directly increase production, but more importantly, will give workers more income. As workers gain income, they in turn will increase their consumption. This in turn will help the industries where workers are spending money. We get a multiplied affect through the economy. So, the government can get the ball rolling and then the private sector takes over.

We have pulled out of a number of recessions with increased government spending. Here are some examples:

  • We pulled out of the Great Depression with an enormous increase in government spending, coming from military spending in World War II. Spending on military-related materials put factories back in businesses. As workers were hired back, this gave them more income, which they were able to spend, which helped other non-military businesses and workers.
  • One of the key reasons why we pulled out of the 1981-82 recession was the very large increase in military spending that occurred under President Reagan. (We often think of President Reagan as being for small government. But, when Reagan doubled military spending, the size of government actually increased.)
  • We pulled out of the 2001-02 recession, in part, from the large increase in military spending under President Bush, largely coming in response to the 9-11 attacks.
  • We pulled out of the 2008-09 recession largely from increased government spendingfirst the $700 billion bank bailout coming from President Bush and then the $500 billion government spending stimulus coming from President Obama. In addition, governments around the world, from China to Europe, increased their own government spending to help get us out of a world-wide recession.
  • As the Covid-induced recession of 2020 resulted in a massive drop in production, Congress passed and President Trump signed in March 2020 the $2.2 trillion CARES Act. The spending included stimulus checks as well as aid directed at small businesses, hospitals, and the unemployed. This helped to change the direction of GDP from a massive drop during the first half of 2020 to a large increase in the second half of 2020. Nevertheless, most economists favored further stimulus packages to help health care businesses, small businesses, the unemployed, and state and local governments which were facing large budget shortfalls. It was not until December 2020 that a follow-up $900 billion stimulus was passed and signed by President Trump, which included stimulus checks and aid for unemployment, rental assistance, and small businesses. And then in March 2021, Democrats passed and President Biden signed into law his $1.9 trillion American Rescue Plan which increased funding for vaccines, stimulus checks, rental assistance, unemployment, small businesses, state and local governments, schools, and food stamps, and increased the child tax credit. All three stimulus packages passed in March 2020, December 2020, and March 2021 have helped to get us out of the 2020 Covid recession.

The spending increases during these five periods helped to pull the economy out of the five recessions.

One important noteas the government increases its spending we are absolutely not implying that the government increases taxes to pay for this spending. If the government simply pumped more spending into the economy but then took it back out with higher taxes, this would have much less of an impact on total spending.We are increasing government spending without increasing taxes. This certainly will have an impact on the budget deficit, which I will come back to.

Why do I not include the 2018 budget agreement that increased government spending, particularly in defense? The other five periods that I talked aboutWorld War II spending, Reagan's military spending, Bush's military and domestic spending, Obama's domestic spending, and the 2020-21 Covid stimulus spendingall occurred in recessions.The 2018 Trump/Republican increase in government spending did not occur in a recession. So, the positive effects of increased government spending were much lower. And, this definitely had a negative impact on the budget deficit, which we will return to.

Taxes

Although taxes are not directly a part of total spending, the government can indirectly influence spending, particularly consumer spending, by changing taxes. In a recession, for example, we can decrease taxes in order to boost consumer spending. This tool has also been used to help get an economy out of recessions. Here are some examples:

  • The Reagan tax cuts helped us get out of the 1981-82 recession.
  • President Bush cut taxes by approximately $3 trillion from 2001-2008. This helped get the economy out of the 2001-02 recession.In the summer of 2002 and 2003, for example, refund checks were mailed out. This allowed consumers to increase their spending, which helped to pull the economy out of the recession.
  • The economic stimulus package of 2009 under President Obama included about $287 billion in tax cuts. This included the Making Work Pay program, where most workers received $400. Rather than getting a check for this, less was taken out of most peoples' paychecks. The cut in the social security tax--taking less out of your paycheck--was extended through the end of 2012 (2% less taken out of your paycheck), along with many of the Bush-era tax cuts. The Obama tax cuts helped us get out of the 2008-09 recession.
  • In response to the 2020 recession, Congress passed the CARES Act, signed by President Trump. As part of the CARES Act, tax refund checks were sent out totaling approximately $400 billion.Then, in December 2020, a second round of stimulus checks was sent out. And, in March 2021, the American Rescue Plan including a third round of stimulus checks as well as an increase in the child tax credit (which acts like a tax cut).

So, the tax cuts of Presidents Reagan, Bush, Obama, Trump (2020), and Biden helped to pull us out of the recessions of 1981-82, 2001-02, and 2008-09, and 2020. What about the 2017 tax cut?

In 2017, President Trump and the Republican-controlled House and Senate passed a $1.4 trillion tax cut. This included a decrease in the corporate income tax rate from 35% to 21%, a reduction in the top personal income tax rate from 39.6% to 37%, and a significantly reduced estate tax, all of which primarily affect the top 1%. Although there were also some changes that might help the middle class, such as an increase in the standard deduction and an increase in the child tax credit, these were offset by the elimination or reduction of other deductions, including the elimination of personal exemptions. So, it is not at all clear that the middle class benefited. What is clear is that the primary beneficiaries of the $1.4 trillion tax cut were the richest 1%.

In addition, what made the 2017 Trump/Republican tax cut different than the 1981 Reagan tax cut, the 2001 Bush tax cut, the 2009 Obama tax cut, and the 2020/2021 tax cuts was that we were not in a recession. With GDP increasing from 2009 to 2019 and unemployment decreasing to a point below the targeted range, there simply was not much room for GDP to increase more than it already had or for additional jobs to be created.Giving such a large tax break to corporations primarily benefits the owners of corporationsstockholders.And, a very high fraction of all stock is held by the top 1%. Arguing that this would have created jobs was just not a reasonable argument with such a low rate of unemployment. Some making this argument switched to arguing that workers would get pay increases.But, the primary driver of pay increases is the low unemployment rate. Trying to help workers by giving tax cuts to corporations is not a very effective way of helping workers. In fact, one of the reasons for the large redistribution of income that has taken place over the last 50 years from the middle class towards the top 1% has been the change in tax policy that has primarily benefited the rich and the 2017 tax cut continued more of the same.

Besides the redistributional effect of the 2017 tax cuts, the main impact was to reduce tax revenue. Both the Congressional Budget Office CBO and the Committee for a Responsible Federal Budget CRFB have estimated that the 2017 Trump/Republican tax cut will reduce tax revenue by about $1.4 trillion over 10 years, adding $1.4 trillion to the budget deficit and the national debt. There are very few economists who favor policies that cause the deficit and debt to increase when we are not in recessions.

But, when we are starting from a recession, we can stimulate the economy with either conservative or liberal policies. If you are a conservative who favors smaller government, you would want to cut taxes to help out the economy. (This will also put pressure on reducing government spending down the road.) If you are a liberal in favor of more government spending on things like education and infrastructure then you would want to stimulate the economy through increased government spending (which will put pressure on raising taxes down the road to pay for the spending).

Budget Deficit

A budget deficit occurs when government spending is greater than tax revenue...so the government spends all of its tax revenue and then spends even more on top of that. A budget surplus occurs when tax revenue is greater than government spending.Here is a brief history of the budget deficit in the United States over the last 70 years or so. (You are not expected to memorize all the numbers, but just to pick up a sense of some of the trends in the budget deficit and what types of government policies help or hurt the deficit.)

1943 Budget deficit of $55 billion (or about 30% of GDP). The large increase in government spending during World War II helped to bring the economy out of the Great Depression.

1969 Budget Surplus (the last budget surplus for the next 29 years)

1979 $41 billion budget deficit (1.6% of GDP)

1986 $221 billion budget deficit (5% of GDP). The large rise in the deficit came from large Reagan tax cuts and increases in defense spending.

1992 $290 billion budget deficit (4.7% of GDP).More tax cuts, a recession (where people pay less in taxes and the budget deficit automatically increases), rising health care costs (which continue to be an issue), the savings and loan crisis (where many savings and loans failed and government spending was needed due to deposit insurance), and rising interest on the national debt.

1998 $70 billion budget surplusthe first surplus in 29 years, coming from a strong recovery (where people automatically pay more in taxes as their incomes rise), some Clinton tax increases, and some Clinton cuts in government spending.

2000 $236 billion budget surplus at the end of the Clinton Administration, with the 10 year budget predicted to total a surplus of $5.5 trillion! So, not very long ago, the financial health of the United States government was in fantastic shape.

Unfortunately, 2000 was an election year and in many ways the 2000 election between George Bush and Al Gore was over who could blow the surplus the quickest, with President Bush favoring a massive tax cut and Al Gore favoring more spending on education and the environment (and then getting into a tax cut war with Bush).

Economists, on the other hand, were not sure why we would want to get rid of the surplus. Most importantly, perhaps, because it was not our surplus to blow, it was social security's surplus. Long ago, the budget of social security had been merged with the federal budget. So, this was social security's surplus.While social security is currently in okay shape, with more people paying into social security than are taking out, the problem will occur as baby boomers start retiring. Once this happens, social security is projected to go into a very big deficit.

At any rate, President Bush won and, unfortunately, we then went into a recession. The recession had nothing to do with President Bush (or President Clinton for that matter). But it did have a negative impact on the budget and the projected surpluses. This is another reason not to spend the projected surpluses or give them back in tax cuts because they are projected on having a strong economy. Once we entered the 2001-02 recession, the surpluses started to come down.

President Bush then passed a $3 trillion tax cut, one of the largest tax cuts in history. Even when we were well out of the 2001-02 recession, the federal government continued running a very large budget deficit.

2004 $413 billion budget deficit (3.5% of GDP).The 6 year budget projection was now between a $1 trillion and $2 trillion deficit...quite a dramatic change from the projected $5.5 trillion surplus in 2000. And, it gets worse. The deficit started to get a bit better but then we entered the 2008-09 recession. We enacted a relatively small $170 billion tax cut in 2008.

2008 $459 billion budget deficit (3.2% of GDP).

When the banking collapses started, President Bush signed an emergency $700 billion banking bailout. The projected budget deficit for 2009 as Bush left office (fiscal year 2009 starts October 2008):

2009 Projected: $1.2 trillion budget deficit (9.5% of GDP) projected as President Bush leaves office.

When President Obama took office he passed a $787 billion stimulus package (also called the Economic Recovery and Reinvestment Act of 2009), which consisted of a $500 billion increase in government spending combined with a $287 billion tax cut. This was projected to increase the budget deficit an additional $787 billion, but we finished 2009 at "only" a deficit of $1.4 trillion.

2009 $1400 billion budget deficit (10% of GDP)

2011 $1300 billion budget deficit (8.7% of GDP)

2013 $ 680 billion budget deficit (4.0% of GDP)

2016 $ 587 billion budget deficit (3.1% of GDP)

Before moving on to President Trump, two notes about President Obama's impact on budget deficits. First, there is no question that his 2009 stimulus package contributed to the 2009 budget deficit. But to completely blame the 2009 deficit increase on President Obama (as Michele Bachmann did in an infamous Tea Party speech in 2011 following President Obama's State of the Union speech and the Republican response by Paul Ryan) is very misleading since President Bush's $700 billion bank bailout occurred in fiscal year 2009 before he left office. Secondly, comparing the estimated $1.2 trillion budget deficit that was handed to President Obama with the $587 billion budget deficit that Obama then handed to President Trump, we see a significant decrease in the budget deficit under President Obama.

The 2017 tax cut combined with the 2018 budget agreement to increase government spending, particularly military spending, led to an increase in budget deficits under President Trump. In fact, this is the largest increase in budget deficits outside of recessions that we have ever seen.

2017 $ 666 billion budget deficit (3.5% of GDP)

2018 $ 779 billion budget deficit (3.9% of GDP)

2019 $ 984 billion budget deficit (4.6% of GDP)

In good times, you want to be running a balanced budget or even a budget surplus. Running a $1 trillion deficit in good times presents a problem when the next recession hits, as it did in 2020.

In 2020, Congress passed and President Trump signed the $2.2 trillion CARES Act. This combined with the recession significantly increased the 2020 budget deficit, which ended in September 2020.

2020 $3.1 trillion budget deficit (14.9% of GDP)

In the 2021 fiscal year (which runs October 2020 to September 2021), we had the $900 billion stimulus package signed by President Trump in December 2020 as well as the $1.9 trillion 2021 American Rescue Plan signed by President Biden. Offsetting this was the increase in GDP and incomes, resulting in higher tax revenue.

2021 $2.8 trillion budget deficit (12.4% of GDP)

In November 2021 (which is part of the 2022 budget year), President Biden signed a $1.2 trillion infrastructure bill. This included increased spending on bridges, roads, ports, airports, water, energy, electric vehicles, and high-speed internet. However, the Congressional Budget Office has estimated that this will only add $360 billion to the debt spread out over 10 years because most of it is paid for with increased fees, control over health care spending, and increased IRS tax revenue. In August 2022, President Biden signed what was called the Inflation Reduction Act.This included spending to combat climate change, extending the Affordable Care Act, and IRS tax enforcement.This is paid for with a minimum tax on corporations that make more than $1 billion in income (15%), lower prescription drug prices, and increased tax revenue. Note that it is estimated that for every $1 we spend on IRS tax enforcement, an additional $7 is brought in in increased tax revenue. Thus, spending on IRS tax enforcement is one of the few areas in which increased spending actually reduces the budget deficit. On the one hand, the Congressional Budget Office has estimated that the bill will have very little impact on inflation. On the other hand, the net impact of the bill has been estimated to reduce the budget deficit slightly. So, while the bill will not solve inflation, it also does not increase inflation since deficit spending will not go up.

2023 $1.7 trillion deficit (6.6% of GDP)

In the graphs that follow, we see budget deficits as a percent of GDP since World War II. First, note that the budget deficits over the last 30 years are nothing compared to the deficit spending that occurred during World War II. But also note, that it was the spending from the war that ultimately brought us out of the Great Depression. Also note that over the last 40 years since President Reagan, budget deficits have tended to go up under Republican Presidents and have tended to go down under Democratic Presidents. A key reason for that is that Republican Presidents have tended to increase military spending. President Reagan, for example, doubled military spending (in real terms, after correcting for inflation). And, since military spending is such a large part of total government spending, if you are in favor of big military, you are in favor of big government, period. And, in addition to the increased military spending, Republican Presidents have tended to decrease taxes. The lower tax revenue also leads to increases in the budget deficit.

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10 -5 0 un 10 15 20 25 30 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 Deficit as Percent of GDP 1981 1982 1983 1984 1985 1986 Reagan 1987 1988 1989 1990 1991 Bush 1992 1993 1994 1995 1996 1997 1998 Clinton 1999 2000 2001 2002 2003 2004 2005 2006 Bush 2007 2008 009 B 009 0 2010 2011 2012 2013 2014 Obama 2015 2016 2017 2018 Trump 2019 2020 2021 2022 Biden

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