Macroeconomics

1.Define/explain the following:

a.What are the three goals of fiscal policy?

b.What are the three goals of fiscal policy?

c.What the Laffer curve shows.

d.Automatic fiscal policy

2.List the:

a.Sources of U.S. tax revenue in order, largest to smallest.

b.List the categories of federal government outlays from largest to smallest.

Component Personal income taxes Social Security taxes Corporate income taxes Indirect taxes Transfer payments Expenditures on goods and services Debt interest Dollars (billions) 950 400 200 50 1000 500 300 \fW H AT I S E C O N O M I C S ? 451 C h a p t e r 1 3 FISCAL POLICY* 451 Fiscal policy refers to changes in government expenditures and taxes to impact the economy. I. The Federal Budget The annual statement of the outlays and tax revenues of the government of the United States together with the laws and regulations that approve and support those outlays and taxes make up the federal budget. The use of the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability is called fiscal policy. The Institutions and Laws The Council of Economic Advisers monitors the economy and keeps the President and the public well informed about the current state of the economy and the best available forecasts of where it is heading. Sources of Government Revenues: 1. Personal income tax - Largest 2. Social Security Tax 3. Corporate income tax 4. Indirect taxes (things like gas tax, tariffs, etc) Government Outlays 1. Transfer payments (e.g. Social Security benefits, unemployment benefits, etc) 2. Expenditures on Goods and Services 3. Debt interest Budget balance = Tax revenues - Outlays If tax revenues exceed outlays, the government has a budget surplus. T>G If outlays exceed tax revenues, the government has a budget deficit. G>T If tax revenues equal outlays, the government has a balanced budget. G=T If the government has a deficit, how could they get rid of it? Raise taxes or decrease spending. Government debt is the total amount that the government has borrowed. A budget deficit adds to the government debt. o Debt is the sum of past budget deficits minus past budget surpluses Budget deficits add to government debt. Budget surpluses reduce government debt Year Tax Revenues 1 2 3 100 105 110 Govt Expenditures 110 105 105 Budget Balance Deficit: 10 Balanced Surplus: 5 Debt (start with $5 debt) $5+$10 = $15 $15 $15-$5 = $10 II. The Supply Side: Employment and Potential GDP The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects. The Effects of Taxes on Full Employment and Potential GDP The labor market determines the full employment quantity of labor, which, together with the production function, determine potential GDP. An income tax decreases the supply of labor and shifts the supply of labor curve leftward. o A wedge is driven between the before-tax wage rate that firms pay and the after-tax wage rate that workers receive, called the tax wedge. 490 o Because of the tax wedge, the level of employment decreases, so potential GDP decreases. If the income tax were lowered, employment would increase and potential GDP will increase. W H AT I S E C O N O M I C S ? 491 Tax Revenues and the Laffer Curve The relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve. If the tax rate is zero percent, the government will collect zero tax revenue. If they raise the tax rate, tax revenue will increase. But if they raise it too high, let's say to 100%, we will stop working and the government will receive zero tax revenue. Figure 14.8 illustrates the Laffer curve. As the tax rate increases, tax revenues initially increase. But above a certain level, an increase in the tax rate causes tax revenues to fall. IV. Generational Effects of Fiscal Policy So what effect will the budget deficit burden future generations? What about the deficit in the Social Security fund? What about all the debt owned by foreigners? The Social Security Time Bomb In 2008, the baby boomers started retiring. In 2011, they became eligible for Medicare benefits. By 2030 all baby boomers will have retired and the population supported by the social security system, as compared to 2006, will have doubled. Social Security and Medicare together accounted for 42 percent of Federal program expenditures in fiscal year 2016. Trust funds are expected to be depleted in 2034. Under existing Social Security laws, the federal government owes these citizens pensions and Medicare benefits. It is a debt of the government. Fiscal imbalance is the present value of the government's commitments to pay benefits minus the present value of its tax revenues. How is the government going to meet these obligations???????? Gokhale and Smetters (Study in 2002) There are - four alternatives for redressing the fiscal imbalance: o raise income taxes, o raise social security taxes, o cut social security benefits, or o cut federal government discretionary spending. 491 o However, income taxes would need to be raised by 69 percent; or social security taxes raised by 95 percent; or benefits cut by 56 percent. (The study was done a long time ago so the percentages would be even higher today) V. Stabilizing the Business Cycle A fiscal action that is initiated by an act of Congress is called discretionary fiscal policy. (Similar to the bills they are trying to pass to help with Coronavirus - I am writing this on 3/19 - they will hopefully have passed something when you read this) A fiscal action that is triggered by the state of the economy is called automatic fiscal policy. o Automatic fiscal policy does not require an act of Congress. Will automatically work to reduce the effects of a recession or expansion. Discretionary Fiscal Stabilization If timed correctly and of the correct magnitude, discretionary fiscal policy can be used to push the economy to potential GDP. Expansionary fiscal policy o (an increase in government expenditure or a decrease in taxes) seeks to eliminate a recessionary gap; o Shifts AD to right o Price level increases/ real GDP increases Contractionary fiscal policy (shown in graph) o (a decrease in government expenditure or an increase in taxes) seeks to eliminate an inflationary gap. o If real GDP > potential GDP Government should increase taxes or decrease spending. Limitations of Discretionary Fiscal Policy In practice, discretionary fiscal policy is hampered by three time lags: Recognition Lag: The recognition lag is the time it takes to figure out that fiscal policy actions are needed. (Data is sometimes infrequent (e.g. quarterly GDP data) Law-Making Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending. (We know how well they work together) 492 W H AT I S E C O N O M I C S ? 493 Impact Lag: The impact lag is the time it takes from passing a tax or spending change to implementing the new arrangements and feeling their effects on real GDP. Automatic Stabilizers Automatic stabilizers are aspects of tax revenues and expenditures that fluctuate with real GDP to help stabilize real GDP without explicit action by the government. Taxes that vary with disposable income are called induced taxes. o In an expansion, induced taxes rise, helping to stabilize the economy o In a recession, induced taxes fall, helping to stabilize the economy. Government expenditure on programs that pay benefits to people and businesses depending on their economic status is called needs-tested spending (welfare, unemployment benefits are two examples). o Needs-tested spending increases in a recession and decreases in an expansion, helping to stabilize the economy. Unemployment benefits Food stamps Automatic stabilizers mean that the federal budget deficit is counter-cyclical, with the deficit increasing in a recession and decreasing during an expansion. The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit. This is the deficit that occurs just because we are in a recession. Remember that in a recession, the government will receive less tax revenue and will spend more through needs tested spending (e.g. unemployment benefits, welfare). The Total deficit is the sum of the structural and cyclical deficits. 493 * Year Government Tax Revenues (billions) Government expenditures (billions) 1 4200 4400 2 4600 4500 3 4700 4700 4 4500 4400 5 4000 4300