When Bill Clinton became president in January 1993, his administration's primary challenge was to contain the budget deficit and support the U.S. economy that was recovering from the 1991 recession. President Clinton proposed a fiscal strategy comprising a deficit-reduction package by means of a tax increase together with a stimulus package to ease the short-run effects of the fiscal contraction. Assume that consumers were not Ricardian and that the U.S. is a closed economy that was at full employment before implementing Clinton's fiscal mix.

a) How does the tax increase (this policy only) affect the economy in the short run? What is the effect on the aggregate demand? Illustrate your answer on the AD-SRAS-LRAS diagram. It turned out that 80 percent of the personal tax increase fell on the most affluent 1% of Americans (those with annual incomes above $200,000) who would pay 17 percent more taxes. For income groups between $30,000 and $200,000, total taxes rose approximately by 1 percent. For taxpayers whose income was below $30,000, there was no change in taxes.

b) Given that wealthier people have a lower marginal propensity to consume, did the distribution of the tax burden selected by the Clinton administration alleviate or worsen the contractionary effect of the tax increase? Explain by comparing the Clinton tax increase with a tax increase that is evenly divided across income groups. The stimulus package provided $4 billion in additional unemployment benefits (a transfer).

c) Does the provision of unemployment benefits alleviate or worsen the contractionary effects of the tax increase? Explain and illustrate your answer on the graph of part a).

In what follows, assume that the fiscal policy caused a contraction in the AD. You don't need to have answered the previous questions.

d) Was the Clinton fiscal policy mix inflationary or deflationary in the long run? What was the effect on unemployment in the short run? Explain.

Consider now the effects on labor supply. A Republican economist argued that Clinton's policy would have caused taxpayers to work shorter hours and take longer vacations, thereby producing less taxable income. In contrast, a Democrat economist claimed that people would have worked more rather than less, in order to keep their after-tax incomes at the same level.

e) Which economist focuses on the effects of marginal taxes (i.e. on the substitution effect)? Who focuses on the effects of average taxes (i.e. the income effect)?

f) If the Democrats were right, how would the increase in taxes shift the LRAS? What would be the long-run effect on employment and on the average productivity? Illustrate your answer on an LRAS-AD diagram. Would the shift in LRAS make the fiscal policy more or less deflationary? What monetary policy would the U.S. economy need to offset the deflationary pressures?