Chapter 11

Managing Aggregate Demand:

Fiscal Policy

Next, let us turn to the problems of our fiscal policy.

Here the myths are legion and the truth hard to find.

JOHN F. KENNEDY

Roadmap

• Chapter 8-10 establish the theoretical framework of the macro economy: AS-AS-AD equilibriumAD equilibrium

• Chapter 11-16 turn to the government government policypolicy– Fiscal policy (Chapter 11)

– Monetary policy (Chapter 12, 13)

– Debate and trade-off (Chapter 14-16)

Question for This Chapter

• How do taxes (T) affect equilibrium GDP (Y)?

Tools of Fiscal Policy

• Government spendingGovernment spending (G)• Income TaxIncome Tax (T)• Government TransferGovernment Transfer (GT)

Income Taxes & Consumption Schedule

• Tax affects disposable income (DI = Y-TT)– Real GDP (Y)

– Taxes (T)

5

Income Taxes & Consumption Schedule

• Tax increase– Consumption schedule – shift downward

– Total spending schedule – shift downward

– Equilibrium GDP (demand side) – reduced

• Tax decrease– Consumption schedule – shift upward

– Total spending schedule – shift upward

– Equilibrium GDP (demand side) - increased

6

How tax policy shifts the consumption schedule

Figure 1

7

Real GDP

Rea

l Con

sum

er S

pend

ing

C

Tax Increase

Tax Cut

The Multiplier Revisited

• Change in government purchases GG– Every dollar - spent

– Multiplier effect ( ∆G/∆Y=1/(1-MPC) )

• Change in taxes TT– Not every dollar is spent

– Multiplier – smaller

8

The Tax Multiplier: Fixed Tax

• Increase in GIncrease in G by 1 million∆Y= 1 + 0.75 + 0.75^2 +0.75^3 + …… = 4

• Decrease in TDecrease in T by 1 million∆Y= 0.75 + 0.75^2 +0.75^3 + …… = 0.75(1+0.75+0.75^2+0.75^3+……)

= 0.75*4 = 3

The Tax Multiplier: Variable Tax

• Proportional income tax t=20%• Increase in G by 1 million

∆Y = 1 + 0.75*(80%) + (0.75*80%)^2

+ (0.75*80%)^3 + ……

= 1 + 0.6 +0.6^2 +0.6^3 + …..

= 1/(1-0.6) = 2.5

∆∆Y = 1/(1-(1-t)MPC)Y = 1/(1-(1-t)MPC)

The Multiplier Revisited

• Multiplier– Reduced by income taxReduced by income tax

– Income tax• Reduces - fraction of each dollar of GDP

– Consumers actually receive and spend

• Oversimplified formula 1/(1-MPC)– Overstates multiplier

1.Ignores variable importsvariable imports (Chp. 9)

2.Ignores price-level changesprice-level changes (Chp. 10)

3.Ignores income taxincome tax 11

The multiplier in the presence of an income tax

Figure 2

12

0Real GDP

Rea

l Exp

endi

ture

45°

6,000

C+I+G0+(X-IM)

E0

C+I+G1+(X-IM)

7,000

$400

E1

The Multiplier Revisited

• Taxes – change multiplier analysis– Fixed tax changes (TT) - smaller multiplier

effect • Than changes in spending

– Variable income tax (tt) - reduces multipliers for• Tax changes• Changes in spending

13

The Multiplier Revisited

• Automatic stabilizerAutomatic stabilizer– Feature of economy

– Reduces its sensitivity to shocks• Sharp increase/decrease in spending

– Automatically – shock absorber• Lower multiplier → less volatile

– Example• Personal income taxPersonal income tax• Unemployment insuranceUnemployment insurance

14

The Multiplier Revisited

• Government transfer payments– Payments to individuals

• Not compensation for production

– Add to income

– Function as negativenegative taxes

– Net T = taxes - transfers

15

Planning Expansionary Fiscal Policy

• Expansionary fiscal policy– Raise government purchases (G↑)

– Reduce taxes (T↓)

– Increase transfer payments (GT↑)

• T↓ + GT↑ → Net T↓ → DI=Y - Net T increase → C ↑

• AD = C + I +G + (X-IM) ↑• To close recessionary gap

– Between actual and potential GDP16

Fiscal policy to eliminate a recessionary gap

Figure 3

17

0

Real GDP

Rea

l Exp

endi

ture 45°

6,000

C+I+G0+(X-IM)

7,000

Potential

GDP

(a)

Rea

l Exp

endi

ture 45°

0

Real GDP

6,000

C+I+G0+(X-IM)

7,000

Potential

GDP

(b)

C+I+G1+(X-IM)F

E

Recessionary

gap

Expansionary fiscal policy

Figure 4

18

Real GDP

Pric

e Le

vel

D0

D0

S

S

D1

D1

A

E

Rise in

real GDP

Rise in

Price level

Planning Contractionary Fiscal Policy

• Contractionary fiscal policy– Reduce government purchases (G↓)

– Increase taxes (T↑)

– Reduce transfer payments (GT↓)

• AD = C + I + G + (X-IM) ↓• To close inflationary gap

– Between actual and potential GDP

• Can avoid inflation

19

Choice: Spending Policy & Tax Policy

• Policy Alternative: GG or TT• Case 1: Fixed Taxes (MPC=0.75)Case 1: Fixed Taxes (MPC=0.75)

– TT 400 400 YY 1200 1200

– GG 400 400 YY 1600 1600

• Case 2: Variable Taxes (t=20%)Case 2: Variable Taxes (t=20%)– TT 400 400 YY 750 750

– GG 400 400 YY 1000 1000

• G↑ directlydirectly increases AD; T↓ indirectlyindirectly increase AD through consumption

20

Choice: Spending Policy & Tax Policy

• Higher spending, or lower taxes, or a combination of these two tools theoretically will achieve – Same increase in AD curve

– Same increases in real GDP and prices

Choice: Spending Policy & Tax Policy

• In practice, the choice depends on how large a public sector policy-makers want to create

• Conservatives small government advocate T (recession) or G (boom)

• Liberals large government

advocate G (recession) or T (boom)

22

Some Harsh Realities

• Theory shows gov can drive GDP to any level they want by using fiscal policy

• Reality is more complicated– I, X-IM, C schedules

• Shift with– Expectations (often driven by policy itself),

Technology, Events abroad, Other factors

– Multipliers – not precisely known

– Target - full-employment GDP dimly visible

– Fiscal policies have time lags23

Some Harsh Realities

• Legislation level, lower unemployment rate through G↑ and T↓– Long-run costs (Chp. 15)

• Running large budget deficits

– Inflationary cost• How large can we bear

• Seems for expansionary fiscal policy, we always face a dilemma b/w low low unemploymentunemployment and high inflationhigh inflation

• Any way out?24

Idea Behind Supply-Side Tax Cuts

• Supply-side economicsSupply-side economics believes certain types of tax cuts– Increase aggregate supplysupply

• Increase supply of labor & capital • Reduce inflation• Raise real GDP

25

Idea Behind Supply-Side Tax Cuts

• Examples of supply-side tax cuts– personal income tax ratepersonal income tax rate stimulate

incentive of working, labor supply ↑ – tax on income from savingtax on income from saving more

saving more investment – tax on capital gaintax on capital gain stimulate

investment and capital formation– corporate income taxcorporate income tax– With more labor and capital supply, AS

curve ↑

The goal of supply-side tax cuts

Figure 5

28

Real GDP

Pric

e Le

vel

D

DS0

S0

A

S1

S1

B

A successful supply-side tax reduction

Figure 6

29

Real GDP

Pric

e Le

vel

D0

D0

S0

S0

E

S1

S1

D1

D1

A

C

Idea Behind Supply-Side Tax Cuts

• Undesirable side effects– Small magnitude of supply-side effects– Stronger demand-side effects

• Tax cut may possiblypossibly induce individuals work work moremore. But they will certainly spend morecertainly spend more

– Problems with timing• Primary short-run effect on AD, effects on AS

come later

– Effects on income distribution• Increase income equality

– Losses of tax revenue, bigger deficit 30

A more pessimistic view of supply-side tax cuts

Figure 7

31

Real GDP

Pric

e Le

vel

D0

D0

S0

S0

E

S1

S1

D1

D1

C

Summary• Tools of fiscal policy: G, T and Transfer• Multiplier for change in T is smallersmaller than that

for change in G• A proportional income tax t reducesreduces multiplier• Government transfer acts as a negativenegative tax• Recessionary gap can be cured by G↑ or T↓• Inflationary gap can be cured by G↓ or T↑• Expansionary fiscal policy (G↑ or T↓) can

raise inflationinflation and create budget deficitdeficit• Supply-side tax cutsSupply-side tax cuts push AS and hence avoid

the undesirable results of expansionary policy

APPENDIX A

Graphical treatment of taxes and fiscal policy• Variable taxes

– Vary with GDP

– Personal income tax

– Corporate income tax

– Sales tax

• Fixed taxes– Don’t vary with GDP

– Property taxes

33

How variable taxes shift the consumption schedule

Figure 8

34

Real GDP

Rea

l Con

sum

er S

pend

ing

C

Variable Tax Increase

Variable Tax Cut

APPENDIX A

Graphical treatment of taxes and fiscal policy• Variable taxes

– Flatten the consumption schedule

• Government purchases (goods & services)– Add to total spending - directly

• C + I + G + (X – IM)

35

APPENDIX A

Graphical treatment of taxes and fiscal policy• Higher taxes

– Reduce total spending – indirectly• Lower disposable income• Reduce: C component of C + I + G + (X – IM)

• Government’s actions– Raise or lower equilibrium level of GDP

– Depends on• Spending• Taxing

36

Consumption schedule with fixed vs. variable taxes

Figure 9

37

Real GDP

Rea

l Con

sum

er S

pend

ing

C1

C2

Effects of an income tax on consumption schedule

Table 1

38

(1) (2) (3) (4)

Gross Domestic Product Taxes Disposable Income(GDP minus Taxes) Consumption

$4,5005,0005,5006,0006,5007,0007,500

$9001,0001,1001,2001,3001,4001,500

$3,6004,0004,4004,8005,2005,6006,000

$3,0003,3003,6003,9004,2004,5004,800

The relationship between consumption and GDP

Table 2

39

With Fixed Taxes(T=$1,200)

(from Table 1, Chapter 26)

With a 20 percent Income Tax

(from Table 1)

Y C Y C

$4,8005,2005,6006,0006,4006,8007,200

$3,0003,3003,6003,9004,2004,5004,800

$4,5005,0005,5006,0006,5007,0007,500

$3,0003,3003,6003,9004,2004,5004,800

Line C1 in Figure 9 Line C2 in Figure 9

Total expenditure schedule with a 20% income tax

Table 3

40

(1) (2) (3) (4) (5) (6)

GrossDomesticProduct

YConsumption

CInvestment

I

GovernmentPurchases

GNet Exports

(X-IM)

TotalExpendituresC+I+G+(X-IM)

$4,5005,0005,5006,0006,5007,0007,500

$3,0003,3003,6003,9004,2004,5004,800

$900900900900900900900

$1,3001,3001,3001,3001,3001,3001,300

-$100-100-100-100-100-100-100

$5,1005,4005,7006,0006,3006,6006,900

Income determination with a variable income tax

Figure 10

41

4,0000 6,000

Real GDP

8,000

3,000

4,000

5,000

6,000

7,000

Rea

l Exp

endi

ture

8,000

45°

C+I+G+(X-IM)

E

APPENDIX A

Multipliers for tax policy• Tax multiplier for fixed taxes

– Change in tax• Change in consumer spending

– Vertical shift of consumption schedule

42

The multiplier for a reduction in fixed taxes

Figure 11

43Real GDP

Rea

l Exp

endi

ture

45°

C0+I+G+(X-IM)

6,000

C1+I+G+(X-IM)

6,750

$300

billion

APPENDIX B

Algebraic treatment of fiscal policy

• Y=C+I+G+(X-IM)• C=a+bDI• DI=Y-T

• T=T0+tY

• C=a-bT0+b(1-t)Y

44

APPENDIX B

Algebraic treatment of fiscal policy

45

t)b(-b

multiplierTax

tbMultiplier

tbIMXGIbTa

Y

11

)1(11

)1(1)(0