Fiscal Policy, Deficits, and Debt

Chapter 31

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31-2

Federal Budget

• The federal budget is an annual statement of the revenues, outlays, and surplus or deficit of the government of the United States. (Chapter 18)

• The federal budget has two purposes:• To finance the activities of the federal

government• To achieve macroeconomic objectives

• Fiscal policy is the use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment.

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Fiscal Policy

• Two types of Fiscal Policy• Discretionary fiscal policy: Deliberate changes

in government spending and taxes to achieve its macroeconomic goals.

• Non-Discretionary fiscal policy: Automatic changes in government spending and taxes which affect the macroeconomic conditions.

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Fiscal Policy

• Fiscal policy can be implemented by changes in• Government expenditure: It directly affects

the aggregate expenditure.• Taxes and transfer payments: It indirectly

affects the aggregate expenditure by affecting disposable incomes of households who change their consumption accordingly.

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Fiscal Policy

• Fiscal policy may affect the macroeconomic equilibrium directly or indirectly through affecting• Aggregate demand: Government spending

and taxes affect the aggregate expenditure• Aggregate supply: Government spending and

taxes can change quantities of resources, prices of resources, and state of technology.

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Discretionary Fiscal Policy

• Discretionary fiscal policy depends on the economic condition

• Expansionary fiscal policy is used during a recession to eliminate a recessionary gap, reduce unemployment, and increase real GDP.

• Contractionary fiscal policy is used during an expansion to eliminate an inflationary gap and lower the inflation.

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Expansionary Fiscal Policy

• Expansionary fiscal policy involves• Increase government spending (both expenditure

and transfer payments)• Decrease taxes• Expansionary fiscal policy may create a fiscal

budget deficit.

• Expansionary fiscal policy will increase the aggregate expenditure and the aggregate demand.• Direct effect and multiplier effect

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Expansionary Fiscal Policy

Real GDP (billions)

Pri

ce le

vel

AD0

AD1

$5 billion increase inspending

Full $20 billion increase inaggregate demand

AS

$490 $510

P1

Full-employment GDP is $510 billion & there is $20 billion of recessionary gap

LO1

P0 E0

To eliminate a gap, the government implements an expansionary fiscal policy.

31-9

Contractionary Fiscal Policy

• Contractionary fiscal policy involves• Decrease government spending (both expenditure

and transfer payments)• Increase taxes• Contractionary fiscal policy may create a fiscal

budget surplus.

• Contractionary fiscal policy will decrease the aggregate expenditure and the aggregate demand.• Direct effect and multiplier effect

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Contractionary Fiscal Policy

Real GDP (billions)

Pri

ce l

evel

AD0

$3 billion initialdecrease inspending

Full $12 billion decrease inaggregate demand

AS

$522

P0

AD1

$510

E0

P1 E1

LO1

Full-employment GDP is $510 billion & there is $12 billion of inflationary gap

To eliminate a gap, the government implements a contractionary fiscal policy.

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Policy Options: Expenditure vs Tax

• Effects of government spending changes and tax changes could different in aggregate expenditure• Government expenditure directly rises the

aggregate expenditure by the same amount.• Taxes and transfer payments affect disposable

incomes and only a portion of them (MPC) affects consumption and the aggregate expenditure by the less than the original change in taxes.

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Policy Options: Expenditure vs Tax

• The government can achieve the same goal by either government spending or taxes• Both government spending and taxes have the same effect

on budget. • Those who prefer smaller government in size and role

advocate tax cuts as expansionary fiscal policy and government spending cut as contractionary fiscal policy.

• Those who prefer larger government in size and role advocate expanding government spending as expansionary fiscal policy and tax raise as contractionary fiscal policy.

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Policy Options: Spending vs Investing

• Government spending and taxes can affect current consumption spending or investment for future• Government expenditure on infrastructures and

R&D raise revenue of firms, while transfer payments raise disposable income of households.

• Tax changes on corporate profits and R&D lower costs of firms, while tax returns to households raise disposable income of households

• Depending on how they are spent, they ultimately affect the economic growth.

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Policy Options: Spending vs Investing

• Some government spending and taxes affect capital and technology over time, which will affect the aggregate supply and the potential GDP.• Households’ and government education spending

increases human capital.• Firms’ investment on factories and machineries increase

capital stock of economy.• Government spending on infrastructure increases capital

stock of economy.• Firms’ R&D spending and Government R&D spending

advance technology.• Other government spending and taxes may only affect

current consumption.LO1

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Built-In Stabil i ty

• Non-discretionary (automatic) fiscal policy: a fiscal policy action that is triggered by the state of the economy.• Taxes vary directly with GDP: Tax revenue increases during

expansions and decreases during recessions• Transfer payments vary inversely with GDP: Transfer

payments decreases during expansions and increases during recessions.

• Automatic stabilizers are features of fiscal policy that stabilize real GDP without explicit action by the government.

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Built-In Stabil i ty

• Automatic stabilizers Reduce severity of business fluctuations by automatically counteracting to the business cycle• During an expansion, as national income increases, with

progressive tax system tax revenues increase more proportionally and disposable income and consumption increases less proportionally.

• During a recession, as more workers become unemployed, more unemployment benefits are paid out, and maintain consumption of unemployed households.

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Built-In Stabil i ty

G

T

Deficit

Surplus

GDP1 GDP2 GDP3Real domestic output, GDP

Go

vern

men

t ex

pen

dit

ure

s, G

,an

d t

ax r

even

ues

, T

LO2

• Automatic stabilizers also affect government budget automatically • Deeper the recession, greater the budget deficit.• Greater the inflationary gap, greater the budget surplus.

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Evaluating Fiscal Policy

• Actual budget deficit or surplus is total effect of discretionary fiscal policy and automatic stabilizers.

• To reveal the government’s intention on discretionary fiscal policy (expansionary or contractionary), the actual budget deficit or surplus must be adjusted by effects of automatic stabilizers.

• Cyclically adjusted budget: Estimated federal budget deficit or surplus if the economy is at full-employment level of GDP (eliminating effects of automatic stabilizers).

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Recent U.S. Fiscal Policy

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Fiscal Policy: The Great Recession

• Financial market problems began in 2007• Mortgage market collapsed and credit market

froze• Pessimism spread to the overall economy and

firms’ investment fell• Stock market crashed and households’

consumption fell• Recession officially began December 2007 and

lasted 18 monthsLO4

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Budget Deficits and Projections

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Global Perspective

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Problems of Fiscal Policy

• Fiscal policy may not be implemented and show effects in timely manner• Recognition lag: It takes time to recognize the

state of economy and problems – it takes time to collect data and forecast future course of economy precisely

• Administrative lag: It takes Congress to pass the laws needed to change taxes or spending

• Operational lag: It takes time to implement taxes and spending changes and to have full effect on the economy

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Problems of Fiscal Policy

• Effects of (Well-timed) Stabilizing Fiscal Policy

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Real GDP

2006 2007 2008 2009 2010 2011

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Problems of Fiscal Policy

• Effects of (Poorly-timed) Stabilizing Fiscal Policy

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Real GDP

2006 2007 2008 2009 2010 2011

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Criticisms on Fiscal Policy

• Political business cycles: Fiscal policy is used for political motivation of re-election of politicians• In re-election year politicians want low

unemployment (happier voters toward incumbents), so they pursue an expansionary fiscal policy without merit. After re-election, they reverse to contractionary fiscal policy to offset.

• Politically-motivated fiscal policy without regard of economic condition may initiate fluctuations of economy.

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Complications of Fiscal Policy

• Future policy expectations: If households and firms expect future reversals of fiscal policy, then they many not respond to fiscal policy.• Tax cut is implemented, but households believe that the

government must raise taxes near future to offset budget deficit, then they may save tax return for future tax payment rather than spending it.

• Off-setting state and local finance • Expansionary fiscal policy by the federal government may

be offset by contractionary fiscal policy of state and local governments

• Crowding-out effectLO5

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Crowding-out Effect

• Crowding-out effect: A deficit-spending and tax-cut expansionary fiscal policy will raise the market interest rate and discourage firms and households from borrowing (crowd-out private borrowers from financial market).

• With less borrowing, firms and households cut their spending and offset the government spending, resulting in no change in aggregate expenditure. Then, the expansionary fiscal policy has no effect on aggregate demand.

• Decrease in firms’ investment also temper future economic growth.LO5

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Current Thinking on Fiscal Policy

• Let the Federal Reserve handle short-term fluctuations

• Fiscal policy should be evaluated in terms of long-term effects

• Fiscal policy focuses on long-run effect of economic growth• Use tax cuts to enhance work effort, investment,

and innovation• Use government spending on public capital

projects, R&D, and human capitalLO5

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The U.S. Public Debt

• National debt: The amount of debt outstanding that arises from past budget deficits• National debt clock: http://www.usdebtclock.org/• $19.2 trillion in April, 2016• As federal budget deficits continue and widen in future,

the national debt will increase even faster

• The federal government finances its deficit by issuing U.S. Treasury securities.

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The U.S. Public Debt

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The U.S. Public Debt

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Global Perspective

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The U.S. Public Debt

• Large national debt is a concern of• Interest payments on debt amount 6% of federal

government spending.• 33% of national debt are held by foreigners• Burdening future generations

• Large national debt will not lead to bankruptcy of the U.S. government• About 70% of GDP• U.S. government can refinance or collect taxes to

payLO5

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Social Security, Medicare Shortfal ls

• More Americans will be receiving benefits as they age• Social security shortfall: Funds will be depleted by

2033• Medicare shortfall: Funds will be depleted by 2024

• Possible options “to fix” include:• Increasing the retirement age• Increasing the portion of earnings subject to the

social security tax• Disqualifying wealthy individuals• Defined contribution plans owned by individuals

(privatization of social security)