Final Paper due Monday Midnight/8 pages

Learning Outcomes

By the end of this chapter, you will be able to:

• Define fiscal policy and recognize the relationship between it and monetary policy.

• Identify how fiscal policy works.

• Describe how the government uses fiscal policy to promote growth and employment through both demand and supply effects.

• Understand discretionary fiscal policy and provide historical examples of its use.

• Critically analyze the arguments for and against active fiscal policy.

9

Taxes, Government Spending, and Fiscal Policy

Image Source/Corbis

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CHAPTER 9Pre-Test

Introduction

In 2008, then Senator Barack Obama ran for president on a platform of change and reform in Washington. In the last few months of the election campaign, the economy became the linchpin of the race to the White House. Alarming signs of what we now refer to as the Great Recession were looming. One of President Obama’s first economic measures was the passing of a stimulus package that included bank bailouts, tax rebate checks, and other stopgap measures to stop the slowdown in the economy. In the language of economics, this stimulus program was meant to increase economic growth and stop the bleeding from the economic downturn of 2007. The centerpiece of Obama’s stimulus and recovery program was the continuation of the Bush tax cuts of 2001 and 2003, which was not without controversy. Did the tax cuts go too far? Not far enough? The tax cut was billed as supply-side economics—a collection of policies intended to shift aggregate sup- ply to the right by encouraging investment. Keynesians argued, however, that this tax cut was actually Keynesian fiscal policy, designed to increase aggregate expenditures, aggre- gate demand, and the level of output and employment. Who was right? This chapter may not provide the answer, but it will help you to understand both sides of the argument.

Pre-Test

1. The Keynesian argument for fiscal policy maintains that the economy is basically stable.

a. True b. False

2. Keynesian fiscal policy always calls for an increase in government spending or a decrease in taxes.

a. True b. False

3. Transfer payments are an example of an automatic stabilizer. a. True b. False

4. Following the Reagan tax cut, the unemployment rate decreased. a. True b. False

5. According to the permanent income hypothesis, a temporary tax cut will have a greater impact than a permanent cut in taxes.

a. True b. False

Answers 1. b. False. The answer can be found in Section 9.1. 2. b. False. The answer can be found in Section 9.2. 3. a. True. The answer can be found in Section 9.3. 4. a. True. The answer can be found in Section 9.4. 5. b. False. The answer can be found in Section 9.5.

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CHAPTER 9Section 9.1 Why Fiscal Policy?

9.1 Why Fiscal Policy?

Fiscal policy is based on the Keynesian model in Chapter 8. It consists of changes in government expenditures (G) or taxes (T) in order to influence the level of economic activity, inflation, and economic growth. Government spending and taxes existed, of course, long before the development of Keynesian economic theory.

Defining Fiscal Policy

Discretionary fiscal policy is the intentional use of taxing or government spending to affect the level of output, employment, and prices. Even if governments change their levels of spending or taxes for other reasons, policy makers are very conscious of the effects these actions will have on output, employment, and the price level. Most economists in the classical tradition consider fiscal policy to be of limited benefit, sometimes even harmful. Keynesians, however, regard active fiscal policy as a valuable tool for stabilizing economic activity. Both groups of economists agree that the economy automatically moves to a level of national income where total output equals aggregate expenditure (or where leakages equal injections). In the Keynesian model, however, this equilibrium level may not result in full employment of resources. Keynes argued that governments should respond to unemployment with fiscal policy. That is, government should increase aggregate expen- diture (AE) enough to ensure a socially desirable equilibrium level of income and output.

Aggregate demand consists of consumption, investment spending, government purchases of goods and services, and net exports. An increase in any of these four components can stimulate output and employment. Keynesians, however, do not think it is realistic to expect private demand (consumption and investment) alone to restore full employment.

Households and businesses are motivated more by self-interest than by social interest. Indi- vidual people or firms cannot be expected to act in the interest of society as a whole if those actions would conflict with their own self-interest. In a recession, social interest calls for households to increase consumption spending and business firms to increase investment spending in the face of stagnant demand for their products. Self-interest, however, dictates that it would be foolish for these individual households or firms to swim against the tide by expanding production or consumption while others are contracting. Instead, households tend to save more and spend less because of uncertainty about future income and employ- ment. Business firms invest less because of pessimistic expectations about future income, employment, and sales. During expansionary periods, upbeat expectations of job security, pay raises, and increasing sales and profits stimulate more private spending, pushing the economy further beyond full-employment equilibrium. Thus, the self-interested behavior of households and business firms makes economic fluctuations worse.

The foreign sector also offers little help in ending prolonged downturns. Net exports (X 2 M) are highly variable. Export demand (X) depends on changes in the price level in the United States and abroad, exchange rates, economic conditions abroad, and trade restrictions. Imports (M) reflect changes in the price levels at home and abroad, exchange rates, trade restrictions, consumer tastes, and the domestic income level. A higher level of income stimulates all kinds of private spending, including spending on imported goods. Fortunately, these variables have even less of an impact today because of our global economy.

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CHAPTER 9Section 9.1 Why Fiscal Policy?

With little help from the other three sectors, Keynesians see government spending as the only hope for stabilization. They argue that only the government can be expected to act in the social interest by using its taxing and spending powers to offset changes in private demand.

The Interaction Between Fiscal and Monetary Policy

In contrast to fiscal policy, monetary policy influences the money supply, such as setting a certain interest rate to affect the level of consumption in an economy. Monetary policy controls the credit availability from the central bank, which in turn controls the money supply, which then promotes economic growth and stability. Control is exerted through the monetary system by manipulating the money supply, the level and structure of inter- est rates, and other conditions that affect credit in the economy. These two systems may sound different, but they are closely interwoven—a change in one will influence the effec- tiveness of the other, impacting both and affecting any policy changes.

To illustrate how one affects the other, the following is an excerpt from a speech given in May 2009 by Donald L. Kohn, the vice chairman of the Board of Governors of the Federal Reserve System, in response to the economic recession the United States suffered from 2007 to 2009:

Current economic and financial conditions have not only changed the potential effectiveness of fiscal stimulus, but they also have altered the way in which monetary policy seeks to support economic activity and foster price stability. . . . Experiences studied over a range of countries and peri- ods of history tell us that central banks need a degree of insulation from short-term political pressures if they are to consistently foster the achieve- ment of their medium-term macroeconomic objectives of price stability and high employment.

In more recent years, there have been significant structural changes in the way that fiscal and monetary policies interact. The formation of monetary unions such as the Economic and Monetary Union in Europe has spearheaded these changes. Economists have debated about whether these two policies are complements or substitutes to each other for achiev- ing macroeconomic goals.

To illustrate how they interact, imagine that fiscal policy is used to create jobs and stimu- late the economy in a particular sector. In contrast, monetary policy may affect the hous- ing market because the mortgage loans depend on the interest rates, which in turn drives what consumers will do in the real estate market. Monetary policy is more of a blunt tool because it directly affects interest rates and the cost of borrowing money.

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CHAPTER 9Section 9.2 How Fiscal Policy Works

9.2 How Fiscal Policy Works

Aggregate demand can be very unstable. As consumption spending (C), investment (I), or net exports (X 2 M) fluctuates, aggregate demand changes. Through the multiplier process, the resulting changes in income, output, and employment are larger than the initial change in C, I, or (X 2 M). Upward shifts in the AE curve result in rightward shifts in the aggregate demand (AD) curve, as you saw at the end of Chapter 8. Shifts in aggregate demand lead to changes in the price level as well as in real output and employment. We will work mostly with the model of aggregate supply and demand in this chapter. You should keep in mind, however, that changes in government spending and taxes work by shifting the AE curve, which in turn shifts the AD curve.

Although some forms of fiscal policy may also shift the aggregate supply (AS) curve, fis- cal policy is mainly directed at shifting aggregate demand. If government spending (G) increases only temporarily or taxes (T) are reduced temporarily, then when they return to their original level, the AE and AD curves will return to their original positions. Real output and income will also fall back to the original level.

Figure 9.1 shows how an increase in government spending works in a combined AE/AS/ AD model. In part a, an increase in government spending (G) by an amount of $10 billion shifts the AE curve from AE1 to AE2, increasing the equilibrium level of output from Y1 to Y2. In part b, the shift in AE means a corresponding shift of the AD curve to the right by a horizontal distance corresponding to $10 billion. With an upward-sloping supply curve, however, the impact of the added spending is divided between a change in output (from Y1 to Y3) and a change in the price level (from P1 to P3). Each AE curve is associated with a given price level. Thus, when the price level rises, aggregate expenditure will be lower. As the higher price level feeds back into the aggregate expenditure function, the economy finds itself on a lower AE curve (AE3) in part a, corresponding to a higher price level. The final level of output in both diagrams is Y3.

Key Ideas: The Basics Of Fiscal Policy

• Fiscal policy consists of changes in government expenditures (G) or taxes (T) in order to influ- ence the level of economic activity, inflation, and economic growth.

• In the Keynesian model, governments should respond to unemployment with fiscal policy. • Government should increase aggregate expenditure to ensure a socially desirable equilibrium

level of income and output.

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CHAPTER 9Section 9.2 How Fiscal Policy Works

Figure 9.1: Aggregate expenditure, aggregate demand, and fiscal policy

(a) An increase in aggregate expenditure from AE1 to AE2 because of increased government spending will raise equilibrium output from Y1 to Y2 if there is no change in the price level. (b) The shift in AE also shifts the AD curve from AD1 to AD2, increasing Y by a smaller amount (from Y1 to Y3) and also increasing the price level (from P1 to P3). At the higher price level, the economy’s AE curve will be AE3, correspond- ing to an equilibrium level of output Y3.

Keynesian economists do not advocate government intervention to offset every shift in aggregate demand, only those shifts that have substantial and prolonged effects on out- put, employment, and prices. In reality, major fiscal policy actions have been relatively infrequent during the last 70 years, although minor adjustments to tax schedules, transfer programs, and government purchases with an eye to the economic impact take place in almost every session of Congress.

It is worthwhile to mention here the possibility of the government “crowding out” private investment. The idea behind crowding out is that government spending places upward pressure on interest rates, which in turn reduces private investment. If this is the case, the impact of the expansionary fiscal spending would also be reduced.

The Goal: Full Employment With Stable Prices

In order to use fiscal policy wisely, policy makers must identify a target level of national income. If this target is far from the current equilibrium level, then the government should adjust taxes or spending. The goal is an equilibrium level of national income that gener- ates full employment with price stability. This level is represented by the symbol Y*. In reality, Y* is a range of values clustered around that level rather than a precise, specific number.

0 Y

45 degrees

C, I, G

Y2Y3Y1

AE1

AE3

AE2

0 Y

P (a) (b)

Y2Y3Y1

P3

P1

AD1 AD2

∆G=$ 10 bill

ion

AS

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CHAPTER 9Section 9.2 How Fiscal Policy Works

In the Keynesian model, the aggregate expenditure function is the sum of the four com- ponents of planned spending—C, I, G, and (X 2 M)—at each level of national income. Consumption expenditures were represented in Chapter 8 by the equation C 5 $200 bil- lion 1 0.8Yd. In this consumption function, the marginal propensity to consume (MFC) is 0.8, giving a value of 5 for the expenditure multiplier. The economy in Figure 9.2 is at full employment with stable prices when national income is $3,500 billion (Y* 5 $3,500 bil- lion). Above $3,500 billion lie inflationary pressures. Below $3,500 billion lies unemploy- ment. The equilibrium level of output, which in this case is equal to Y*, is found at the intersection of AE2 and the 45˚ line.

In this situation, the goal of fiscal policy would be to ensure that the level of spending in the economy is AE2 (the level that results in an income of Y*) and not some other level, such as AE1 or AE3. If the level of aggregate expenditure is lower than AE2, unemployment will result. If aggregate expenditure and aggregate demand are above the levels required to bring the economy to full employment, there will be a shortage of workers. Then com- petition for workers and other scarce resources will result in inflationary pressures. The Keynesian model with a given price level is not as useful in addressing the situation rep- resented by AE3 because this model is based on idle resources and a horizontal AS curve, not excess demand for resources and a vertical AS curve. Fiscal policy is still useful in such a situation, but the model must be modified to include a variable price level.

The Recessionary Gap

The difference between the aggregate expenditures and the full-employment level of out- put is called the recessionary gap. A recessionary gap exists when equilibrium national income is less than the desired level Y. In Figure 9.2, planned spending measured by AE1 results in a recessionary gap because the resulting equilibrium level of income is only $3,250 billion. The recessionary gap (measured at Y*) is equal to the vertical distance that AE would have to shift to get from AE1 to AE2. This gap, distance DE, measures how much aggregate expenditure must rise to bring national income up to the desired level. The dif- ference between actual income (Y1) and full-employment income (Y*) is called the income gap. The income gap is equal to the recessionary gap times the multiplier.

A recessionary gap exists when buyers are unwilling to purchase as much output as the economy would supply at the full-employment level of output (Y*). If firms attempt to produce at the full-employment level of output, they will see unplanned increases in inventories and respond with cutbacks in production. Thus, the economy in Figure 9.2 is in equilibrium at Y1.

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CHAPTER 9Section 9.2 How Fiscal Policy Works

Figure 9.2: The recessionary gap

The full-employment level of national income, Y*, is achieved when aggregate expenditure is AE2. If aggregate expenditure is AE1, the recessionary gap is DE.

A recessionary gap such as DE calls for expansionary fiscal policy. Expansionary fis- cal policy consists of cutting taxes, raising transfer payments, or increasing government purchases to try to increase the level of output and employment. Contractionary fiscal policy consists of decreases in government purchases, decreases in transfer payments, or increases in taxes in order to reduce the equilibrium level of output to one that can be produced with available resources.

The tools of government purchases (G) and taxes (T) are already familiar. Transfer pay- ments, first discussed in Chapter 5, are payments from governments to individuals for which no goods or services are expected in exchange. Many of these payments are made to those who are unable to earn enough to meet their basic needs—people who are elderly, single parents of small children, or people with disabilities, for example. Changes in trans- fer payments work like negative taxes. An increase in transfer payments has the same effect on consumption as a reduction in taxes, although the individuals affected are usu- ally a different group. For the economy in Figure 9.2, an upward shift of the curve by $50 billion increases equilibrium income from Y1 to Y*, a gain of $250 billion.

0

AE (Billions of Dollars)

3,250

45 degrees

3,500

3,500 E

50

D 3,250

Y1 Y*

AE 1

AE 2

Y (Billions of Dollars)

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CHAPTER 9Section 9.2 How Fiscal Policy Works

The $250 billion increase in equilibrium income that results from a $50 billion upward shift in aggregate expenditure is a result of the multiplier effect discussed in Chapter 8. (Remember that the multiplier effect is money used to create more money, or the expan- sion of the money supply that results from banks being able to lend.) With MPC 5 0.8, the final change in real output (Y) is equal to the multiplier of 5 times the upward shift in planned spending (AE) of $50 billion. If there is any effect on the price level (in the aggre- gate supply and demand diagram), then the change in real output will be smaller.

Changing the Level of Output With Fiscal Policy

Fiscal policy attempts to close a recessionary gap by increasing aggregate expenditure. In Figure 9.2, an increase in national income of $250 billion (from Y1 to Y*) requires an upward shift in aggregate expenditure of $50 billion. To increase spending by $50 billion at each level of national income (to shift from AE1 to AE2), government expenditures must increase by $50 billion. Through the multiplier process, a $50 billion change in aggregate expenditure causes national income to change by $250 billion.

Another fiscal policy tool is a change in taxes or transfers (Tnet). Changes in transfer payments and personal taxes affect disposable income, which determines consumption spending. A reduction in taxes or an increase in transfer payments will increase dispos- able income, increase consumption, and shift the AE curve upward and the AD curve to the right. An increase in taxes or a decrease in transfer payments will reduce disposable income and consumption, shifting the AE curve downward and the AD curve to the left.

Suppose we want to cut taxes enough to shift AE upward by $50 billion in Figure 9.2. For simplicity, we will assume that taxes are not linked to the level of income, but are some arbitrary value, T, that is determined by Congress. If the marginal propensity to consume (MPC) is 0.8, consumption (C) will increase by 80 cents for every dollar of tax cut. A $10 billion tax cut will increase disposable income by $10 billion and consumption by $8 bil- lion. The change in C is equal to the change in taxes multiplied by MPC:

DC 5 MPC 3 DYd 5 MPC 3 DT

or

$50 billion 5 0.8 3 DT

Taxes must be cut by $62.5 billion at each level of national income in order to generate an initial change in consumption of $50 billion. After the initial change, the multiplier process will generate an increase in income (Y) of $250 billion (the multiplier of 5 times the shift in aggregate expenditure of $50 billion). Because taxes dampen the impact of the multiplier, it takes a $62.5 billion decrease in taxes to accomplish the same change in national income as a $50 billion increase in government spending.

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CHAPTER 9Section 9.2 How Fiscal Policy Works

Fiscal Policy and the Multiplier

Why is the multiplier smaller for a tax change than for a change in government spending? Think about how taxes and government spending enter the income stream. Every dol- lar of additional government spending immediately contributes another dollar to aggre- gate expenditure. On the other hand, every dollar not taken by personal taxes is split between saving and consumption. When the marginal propensity to consume is 0.8, every $1 reduction in personal taxes results in an 80 cent increase in consumption spending and a 20 cent increase in saving.

Recall from Chapter 8 that the equilibrium level of national income is given by

AE 5 Ye 5 C0 1 b 1Y 2 T 2 1 I 1 G 1 1X 2 M 2 where b is the marginal propensity to consume (MPC) and disposable income (Yd) is equal to Y 2 T. We can rearrange this expression:

Ye 5 1

1 2 b 3C0 2 bT 1 I 1 G 1 1X 2 M 2 4

In this rearranged expression, we have separated equilibrium income into two terms. The first term, 1/(1 2b), is the multiplier from Chapter 8. The second term, in brackets, con- tains all the factors that can shift aggregate expenditure: C0, T, I, G, and (X 2 M).

Note that the investment, government spending, net exports, and consumption terms are all multiplied by the multiplier, but the tax term is also multiplied by 2b. This difference between the tax term and the others reflects two important facts. First, changes in taxes work in the opposite direction from changes in all of the other terms. An increase in taxes reduces aggregate expenditure, and a reduction in taxes increases aggregate expenditure. Changes in all of the other terms move aggregate expenditure in the same direction as the change. Second, because b is always less than 1, a change in taxes has a smaller effect on output and employment than has an equal change in any of the other terms. We can express this difference by writing two multipliers: one for consumption (C0), government expenditure (G), and investment (I),

1 1 2 b

and one for taxes (T),

2 ba 1 1 2 b

b 5 2b 1 2 b

For example, with MPC 5 b 5 0.8, the government expenditure multiplier is 5 and the tax change multiplier is 24.

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CHAPTER 9Section 9.2 How Fiscal Policy Works

The Balanced Budget Multiplier

Suppose the government wanted to pursue an expansionary policy but did not want to increase an existing deficit. Since a given dollar amount of change in government spend- ing has a greater impact than the same amount of change in taxes, equal changes in both government spending and taxes would still have some net effect on the equilibrium level of income. Suppose the government increases both spending and taxes by $20 billion, leaving the budget deficit or surplus unchanged. The change in government spending (G) increases the level of income (Y) by the expenditure multiplier, 1/(1 2 b), times the change in G. If b is equal to 0.8, then Y increases by 5 3 $20 billion, or $100 billion. Likewise, the $20 billion increase in taxes (T) is multiplied by the tax multiplier of 24, which is equal to 2b/(1 2 b). So the reduction in Y resulting from the tax increase is 2$80 billion. Thus, the net change in Y from these two offsetting actions is $20 billion—exactly the same as the equal-sized changes in G and T.

Business Tax Cuts as Fiscal Policy

Sometimes there have been changes in business income taxes designed to stimulate investment. One such change was the investment tax credit, first introduced as part of the Kennedy tax cut in 1964. This credit offers tax savings over and above depreciation for business firms investing in new plants or equipment. Firms can subtract a percentage of the investment made from their tax liability. Investment tax credits have evolved since 1964 and are now applied toward the support of energy conservation, pollution control, or various forms of desirable economic development. One such example is the renewable energy investment tax credit introduced in the Ameri- can Recovery and Reinvestment Act of 2009. This particular tax credit varies depending on the type of renewable energy project (solar, fuel cells, small wing, geothermal, microturbines, or combined heat and power plants), but the benefits are derived from the tax credit itself, accelerated depreciation, and cash flow over a 6- to 8-year period.

The investment tax credit in all its forms was designed to stimulate investment. Investment is not only a market for sales of investment goods, but also an addition to the productive capacity of the economy. Thus, both aggregate demand and aggregate supply shift to the right, reducing the inflationary effect of fiscal policy. It is not clear how much additional invest- ment resulted, but there was a definite decline in revenues from the corporate income tax.

Comstock/Thinkstock

LAX airport in Los Angeles, California, received more than $10 million in funds from the American Recovery and Reinvestment Act of 2009 (“Los Angeles Budget Summary 2011–2012,” 2012).

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CHAPTER 9Section 9.2 How Fiscal Policy Works

Supply Side Effects

While fiscal policy is aimed at shifting AD and AE, the composition of government spend- ing and the structure of taxes also affect aggregate supply. Supply-side economics gained attention in the late 1970s and early 1980s as a number of economists, journalists, and poli- ticians focused on the impact of changes in spending, taxes, and transfers on the aggregate supply curve.

Supply Side Effects of Taxes A reduction in corporate income taxes could make business more profitable and stimulate investment, job creation, and output. This reduction could be general (a cut in the corpo- rate income tax rate) or it could be targeted (investment incentives, capital gains tax reduc- tions, etc.) in such a way as to reward firms that invested or created jobs. A reduction in personal income taxes should stimulate both consumption and saving. This reduction can be targeted specifically to savers (for example, tax deductions for retirement savings) or to investment in one’s own human capital (such as deductions for educational expenses).

A tax reduction may also stimulate work effort if workers get to keep a larger share of their earnings, although this effect is less clear cut. Past presidents and their advisers have argued that it was particularly important to cut the tax rate for the highest income work- ers because they were the most productive and their extra work effort greatly increased output. Others have argued that tax cuts at the lower end were also important in getting people off welfare and unemployment because tax cuts meant that these workers could keep a larger share of their earnings. All of these effects would increase labor supply and the stock of capital, shifting aggregate supply to the right.

Supply Side Effects of Government Spending The kinds of government spending most likely to stimulate private investment and pro- duction are improvements in infrastructure (roads, airports, sewer systems) and invest- ment in human capital (mainly education at all levels). Public-sector infrastructure increases the productivity of private capital investment because private firms need the transportation system, the water and sewer systems, and other infrastructure as inputs to their production and distribution activities. Investment in human capital also increases the profitability of firms and encourages increases in output. Thus, while changes in the level of public spending have an impact on aggregate demand, changes in the composition of spending can shift aggregate supply.

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CHAPTER 9Section 9.3 The Tools of Fiscal Policy

Key Ideas: Fiscal Policy: How Does It Work?

• Government should increase aggregate expenditure (AE) via government expenditures (G) and taxes (T) to reach the equilibrium level of national income that generates full employment with price stability.

Expansionary fiscal policy is cutting taxes, raising transfer payments, or increasing govern- ment purchases.

Contractionary fiscal policy is decreasing government purchases, decreasing transfer pay- ments, or increasing taxes.

• Government spending is most likely to positively impact aggregate supply through improve- ments in infrastructure and investment in human capital.

9.3 The Tools of Fiscal Policy

Fiscal policy relies on changes in government spending and taxes (and transfer pay-ments, which can be treated as negative taxes). In general, conservative Keynes-ians prefer tax changes, leaving the level of government spending constant. Liberal Keynesians are more likely to favor changes in government spending or transfer pay- ments. Fiscal policy cannot be considered outside the context of the level and composition of existing government spending.

In the United States, a large share of the nation’s income is claimed by government, and a substantial share of output is produced by or for government.

Government Spending and Taxes

Government spending has been growing faster than the economy as a whole. Between 1950 and 2011, the federal government’s expenditures rose from 15% of gross domestic product (GDP) to 21% (Bureau of Economic Analysis, 2012). Government spending has also increased significantly in recent years, as seen in Figure 9.3. Because government plays such a major role in the economy, changes in its taxing and spending levels can be a very effective tool for influencing the level of income and output.

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CHAPTER 9Section 9.3 The Tools of Fiscal Policy

Figure 9.3: The federal government’s current receipts and expenditures

How does government spending affect the U.S. economy?

Source: U.S. Bureau of Economic Analysis

Total government expenditures—federal, state, and local—account for more than one- third of national income in the United States. The federal government alone spent $1,232 billion in fiscal 2011 (the fiscal year running from October 1, 2010, to September 30, 2011). State and local governments added another $1,475 billion.

About two thirds of these funds were spent to produce or to purchase goods and services, such as defense, health care, highways, police, education, and courts. The rest were trans- fer payments to individuals who provided no goods or services in exchange. These pay- ments included veterans’ benefits, welfare payments, unemployment compensation, and Social Security benefits. Defense and Social Security are the two biggest expenditures for the federal government. Education is the largest item in state and local budgets. Interest on the national debt takes a growing share of the federal budget because of continuing large budget deficits.

200

600

1,000

0

400

800

1,200

1,600

2,000

2,400

1,400

1,800

2,200

2,600 2,800

3,200

3,600

3,000

3,400

3,800

(Billions of Dollars)

19 50

19 53

19 56

19 59

19 62

19 65

19 68

19 71

19 74

19 77

19 80

19 83

19 86

19 89

19 92

19 95

19 98

20 01

20 04

20 07

20 10

Interest payments

Current expenditures

Current transfer payments

Consumption expenditures

Subsidies

Year

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CHAPTER 9Section 9.3 The Tools of Fiscal Policy

Global Outlook: Germany and Japan—A Lesson From History

For more than five decades, the economies of Germany and Japan have performed relatively well. Japan has had spectacular growth in output and is legendary for lifetime employment

and low unemployment. Budget deficits were offset by high levels of private saving. High prices have been the prime complaint. Germany has also had excellent growth, low unemployment, and low infla- tion. Both countries have had strong export performances, excellent productivity growth, reputations for quality products, and strong currencies. But no country is immune to economic downturns.

Japan’s recession in the early 1990s was partly imported—as a nation dependent on export markets, Japan felt the effects of a worldwide recession. Part of Japan’s recession, however, was homegrown, resulting from a speculative bubble in stock and real estate prices that collapsed in 1990. As the Nikkei (the Japanese equivalent of the Dow Jones averages) plunged, and real estate along with it, a lot of fam- ily wealth fell as well. Consumers cut back their purchases, and reduced sales and lowered expectations took their toll on output and eventually even employment. Unemployment approaching 3% may not sound like much to Americans, but Japan is accustomed to a rate of 2% or less.

Germany’s recession was mostly the result of the unification of East and West Germany in 1990. The prosperous west took on the problems of the east—high unemployment, aging factories with no mar- ketable products, obsolete technology, decaying infrastructure, and none of the necessary features of a market system, like private ownership, banks, and marketing networks. High labor costs in the former West Germany led to substantial job losses in 1992 and 1993, with unemployment rising to almost 8%. Germany experienced unaccustomed budget deficits, and tried to stave off inflation with tight monetary policy that resulted in high interest rates, which discouraged borrowing for investment and consumer durables.

The responses of these two countries were different not only from the U.S. response to the recession but also from each other. Unlike the United States, Japan has little in the way of a social safety net to cushion the downturn and provide automatic stabilizers. The Japanese government tackled its first recession in quite some time with a healthy dose of expansionary fiscal policy, adding some $80 million in increased government spending to aggregate expenditures and aggregate demand. This traditional Keynesian response to a recession saw Japan through the worst of the downturn. Japan kept unemploy- ment from going higher while waiting for domestic spending to recover and for the rest of the world to emerge from recession and once again increase their imports from Japan.

Implementing Fiscal Policy: Automatic Stabilizers

There are two kinds of fiscal policy. One kind is put into place and left to respond auto- matically to changes in the level of economic activity. The second kind, used less fre- quently, is deliberate action to change tax laws or enact new spending programs so as to influence the level of output, employment, and prices.

Congressional legislation over the years, much of it enacted during the Great Depression, has created a system of tax collections and transfer payments that change automatically in response to changes in national income. These automatic stabilizers partially offset changes in private spending and tend to reduce fluctuations in output and employment. They primarily include changes in income tax collections, Social Security and welfare ben- efits, and unemployment compensation claims. Because these automatic stabilizers are triggered by changes in the economy, they do not require further action by Congress.

(continued)

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CHAPTER 9Section 9.3 The Tools of Fiscal Policy

Progressive Income Taxes In the Keynesian model of Chapter 8, taxes (T) were independent of level of income. If you have ever filled out Form 1040 to pay income taxes to the Internal Revenue Service, you know that as your income goes up, your taxes go up even faster. That is, your taxes rise as a percentage of income. The federal income tax is progressive, as are some state income taxes.

An income tax, or any tax, can be regressive, proportional, or progressive. Table 9.1 shows examples of how each type of tax affects three income earners. A regressive tax is a tax that takes a smaller share (percentage) of income as income rises. In the “Regressive Tax” column of Table 9.1, Jones pays a higher share of income (5%) than does Brown (1%). Note that a tax can be regressive even if it does not decline in absolute dollars as income rises. In Table 9.1, Brown pays $5,000, and Jones pays only $500. For Brown, however, the tax represents a smaller percentage of income.

Table 9.1: Comparison of amounts paid under three types of taxes

Income Regressive Tax Proportional Tax Progressive Tax

Jones $10,000 $500 5 5% $500 5 5% $500 5 5%

Smith $80,000 $1,600 5 2% $4,000 5 5% $4,000 5 5%

Brown $500,000 $5,000 5 1% $25,000 5 5% $250,000 5 50%

Many people object to regressive taxes because of the burden they place on low-income families. General sales taxes, used by 45 states, are levied on most purchases of goods but very few services. These taxes are regressive because as income rises, a larger share of a household’s income goes to saving and purchases of services rather than tangible goods.

Global Outlook: Germany and Japan—A Lesson From History (continued)

Like other Western European nations, Germany has an extensive social welfare system that triggers automatic changes in benefit payments over the course of the business cycle. These

automatic stabilizers were part of the reason for the budget deficits in 1990 and 1991. With the budget already deep in the red before the recession, the government felt that there was little additional oppor- tunity to respond with tax cuts or increases in government spending. The German central bank reluc- tantly agreed to reduce interest rates in order to encourage borrowing for consumption and invest- ment. Germany also made some effort to trim extensive social benefits (unemployment compensation, day care, health care, and retirement). These cuts would make the economy worse in the short run (remember, a cut in transfer payments is like an increase in taxes in its effect on disposable income and consumption), but in the long run would reduce labor costs and make Germany more competitive in manufacturing.

Faced with a recession, different countries respond with different policy mixes, based on their own situ- ation and their own values. Economic theory can tell you how the economy will respond to a particular policy, but it cannot tell you which policy to choose and implement.

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CHAPTER 9Section 9.3 The Tools of Fiscal Policy

A proportional tax takes the same share (percentage) of income from all taxpayers. A proportional tax is a fixed rate tax. The proportional tax of 5% in Table 9.1 takes the same share of income from each person, but the dollar amount increases as income increases.

A progressive tax takes a larger share (percentage) of income as income rises. In Table 9.1, the progressive tax takes not only more dollars from Brown than from Smith or Jones but a higher share of Brown’s income. If a U.S. citizen earns $10,000 of taxable income (which is income after adjustments, deductions, and exemptions), he or she is liable for 10% of each dollar earned from the first dollar to the 7,550th, and then for 15% of each dollar earned from the 7,551st dollar to the 10,000th, for a total of $1,122.50. This way every rise in a person’s salary will result in an increase of after-tax salary.

The federal personal income tax in the United States has rates ranging from 10% to 35%, in six different tax brackets, as they are commonly called (Internal Revenue Service, n.d.). Since 1960, the U.S. federal tax system has evolved to be far less progressive. In 1960, the top 0.01% of earners paid over 70% of their income in federal taxes; by 2005, the top 0.01% paid only about 35% of their income in federal taxes (Piketty & Saez, 2007). This change occurred while federal tax rates for the middle class have remained roughly the same.

With progressive income taxes, a fall in national income will lead to a more than- proportional fall in tax collections. The disposable income of households will be a larger fraction of total income and output when income falls. Thus, the fall in consumption will be less than proportional to the decline in output and income.

Transfer Payments Transfer payments, many of them dating from the Great Depression, also act as automatic stabilizers. Transfer programs include unem- ployment compensation, Social Security, farm price supports, food assistance, and welfare benefits. All of these programs involve pay- ments for which no production is expected in exchange.

Transfer programs such as food stamps usually set rules that deter- mine who is eligible, rather than specifying a dollar amount to be spent. The number of families eli- gible for transfer programs rises during recessions and falls dur- ing periods of expansion. During

recessions, more people qualify for unemployment benefits, apply for food stamps, go on welfare, and retire early on Social Security. As the economy recovers, some people—even some of those who retired early—go back to work. Transfer payments fall. Think of trans- fer payments as negative taxes. They work in the same way as progressive income taxes

Associated Press

Printed Social Security checks wait to be mailed from the U.S. Treasury.

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CHAPTER 9Section 9.4 Discretionary Fiscal Policy

9.4 Discretionary Fiscal Policy

Automatic stabilizers might be considered Keynesian fiscal policy because they lead to changes in transfer payments and tax revenues that offset changes in private economic activity. For small changes in output and employment, automatic stabi- lizers may be sufficient to cushion the fluctuations until the economy corrects itself. For major swings in aggregate expenditure, however, automatic stabilizers are not enough. Policy makers may turn to discretionary fiscal policy. Discretionary fiscal policy consists of changes in tax rates, levels of transfer payments, or government purchases of goods and services in order to change the equilibrium level of national income.

Congress changes tax rates, transfer programs, and government purchases almost every year for various reasons. The collapse of communism led to a sharp decline in defense spending. Social problems such as AIDS and homelessness put pressure on policy makers to increase spending in those areas. Congress manipulates the income tax code regularly to change incentives to save, invest, or give to charity. These actions may affect the level of economic activity, but they are not really fiscal policy because their primary purpose is not to influence the level of output and employment.

Historical Tax Changes

The Employment Act of 1946 requires the federal government to actively promote full employment, steady growth, and stable prices through the use of fiscal and monetary pol- icy. Nobel Prize winner James Tobin argued that this mandate is still as important today as it was almost 70 years ago. Clear examples of pure, large-scale discretionary fiscal policy are relatively rare. Table 9.2 shows four fiscal policy approaches taken since 1964, illustrat- ing the historical, political, and economic processes at work in discretionary fiscal policy.

Key Ideas: Taxes as Automatic Stabilizers

• Automatic stabilizers change automatically in response to changes in income, including changes in income tax collections, Social Security and welfare benefits, and unemployment-compensation claims. • An income tax can be regressive, meaning it takes a smaller share (percentage) of income as income rises; proportional, meaning it takes the same share (percentage) of income from all taxpayers; or progressive, meaning it takes a larger share (percentage) of income as income rises. • The U.S. federal income tax is progressive.

in stabilizing output and employment by cushioning fluctuations in disposable income. Instead of changes in average tax rates paid as the level of income in the economy rises and falls, there are changes in the number of persons who qualify for benefits.

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CHAPTER 9Section 9.4 Discretionary Fiscal Policy

Table 9.2: Select discretionary fiscal policy changes involving taxes since 1964

President Economic State Type of Fiscal Policy Tax Modification

Kennedy (1964) 5.4% unemployment rate and 2.2% economic growth rate

Expansionary Decrease in personal and corporate income taxes

Johnson (1966) 3.7% unemployment and inflationary pressures

Contractionary 10% surcharge on income taxes for 1 year

Ford (1975) 9% unemployment and high inflation

Expansionary $23 billion tax rebate

Reagan (1981) High unemployment and high inflation

Expansionary Cut personal income taxes by 25% over 3 years; accelerated depreciation for new business investment

More Recent Tax Changes

In the 1990s, as the national debt grew and the annual budget deficit failed to decline, two tax increases and spending cuts were enacted to try to reduce the deficit. The first was the 1990 budget agreement, which occurred at the beginning of the 1990–1991 recession. The second was the Clinton deficit reduction program enacted in 1993, which also involved both tax increases and spending cuts. Neither of these actions was billed as contraction- ary fiscal policy, even though they look like such a policy in a Keynesian model. Both were aimed strictly at controlling the federal budget deficit, which did begin to decline in 1993—partly because of the 1990 budget agreement and partly because of improving economic conditions. Nevertheless, like the Reagan tax cut, they can be analyzed as if they were contractionary fiscal policy.

The agreement reached by Congress and President George H. W. Bush in 1990 to raise taxes and reduce spending generated a great deal of controversy because President Bush was forced to give up his “no new taxes” pledge from the 1988 presidential campaign. Conservative critics, who are normally skeptical about the effectiveness of expansionary fiscal policy, blamed the 1990–1991 recession on the tax increase as contractionary fiscal policy. While the recession was already under way when the tax increase was passed, it may have had some impact on the weak recovery.

President Bill Clinton was aware that his proposals to reduce the deficit with tax increases and spending cuts amounted to contractionary fiscal policy during a period of weak recovery in which growth was slow and unemployment was still high. For that reason, at the beginning of his term in 1993, he proposed a modest ($16 billion) stimulus package (spending for roads, summer jobs for youth, and extended unemployment benefits) for the first 6 months of his term. This stimulus was to be followed by deficit reduction as the economy began to improve. Since the economy appeared to be recovering in early 1993, Congress only approved about one third of the stimulus program, but it did approve a substantial program of tax increases and spending cuts over a 5-year period.

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CHAPTER 9Section 9.5 Limitations of Fiscal Policy

9.5 Limitations of Fiscal Policy

Advocates of fiscal policy as a way to affect output and employment claim that government spending and taxes can be used to reduce, if not eliminate, the social costs of unemployment and inflation. Furthermore, increased government expen- ditures intended to close a recessionary gap can provide needed social goods, such as schools, parks, and highways. However, discretionary fiscal policy has been criticized since its beginnings in the 1930s. Some critics question its effectiveness. Other critics point to the use of fiscal policy for political gain and to an increase in the size of government, budget deficits, and the national debt. Because deficits and the national debt have been a key issue for the last 20 years, they are discussed separately in Chapter 10.

Key Ideas: Discretionary Fiscal Policy in Practice

• Clear examples of pure, large-scale discretionary fiscal policy are relatively rare. • The most recent expansionary fiscal policy acts were the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. • Both acts received a 2-year extension under the Tax Relief, Unemployment Insurance Reautho-

rization, and Job Creation Act of 2010.

President George W. Bush was in office when major changes to the U.S. tax code were made. These tax cuts generally lowered tax rates and revised the tax code. The two acts were known as the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. Both of these acts were set to expire at the end of 2010, but under the leadership of President Barack Obama, who took office in 2008, they received a 2-year extension by being included in a larger tax and economic package called the Tax Relief, Unemployment Insurance Reauthorization, and Job Cre- ation Act of 2010.

Obama had his work cut out for him when he took office in 2009 amid the Great Reces- sion, which the National Bureau of Economic Research specifies as occurring from 2007 through 2009. The recession was caused by the subprime mortgage crisis that led to the collapse of the U.S. housing bubble, a global financial crisis, the failure or collapse of many of the United States’s largest financial institutions (including Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG), and a major crisis in the automobile industry. In response to all of these crises, the government had arranged an unprecedented $700 bil- lion bank bailout known as the Emergency Economic Stabilization Act of 2008 and passed a $787 billion fiscal stimulus package known as the American Recovery and Reinvest- ment Act of 2009. The latter included direct spending in infrastructure, education, health, energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions.

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CHAPTER 9Section 9.5 Limitations of Fiscal Policy

The Permanent Income Hypothesis

The centerpiece of the Keynesian model is the consumption function, C 5 C0 1 bYd, which is the source of the expenditure multiplier, 1/(1 2 b) or 1/(1 2 MPC). In order to increase the level of income and output, the government can cut taxes (raising Yd directly) or increase government spending. The multiplier effect results in further rounds of con- sumption spending. If the consumption function is very stable, the value of the expendi- ture multiplier derived from the consumption function will also be stable.

One modification to the simple consumption function was developed by Franco Modigliani, who pointed out that the consumption behavior of individuals and house- holds depends on where they are over their life cycles. Consumption behavior is very dif- ferent for young families with small children, parents of teenagers and college students, and people who are retired. Modigliani hypothesized that young families would dissave (borrow) to acquire their start-up capital of houses and cars while their current earnings were low but their potential future earnings were high. In the middle years of higher earn- ings, households would pay off debt and save for retirement. During retirement years, households would again become dissavers, drawing on their pool of accumulated savings as their consumption needs exceeded their income.

Modigliani’s ideas were further developed into a critique of the multiplier analysis of fiscal policy by Nobel Prize winner Milton Friedman. This critique was based on Fried- man’s permanent income hypothesis. The permanent income hypothesis is the view that consumption does not depend on current income alone, but on past income and expected future income as well. Think about your own consumption. Today’s spending is not based just on today’s income. If you are paid every other week, you do not consume very heav- ily on payday and then not at all for the next 13 days! Some people may come close to that pattern, but a household’s consumption usually depends on its expected income over time. Friedman argues that consumption depends on permanent income, which consists of past, present, and expected future income. Consumption is much more stable than actual current income because it is not based on that income alone.

Another way of understanding the permanent income hypothesis is to think about what you would do if you had less income for a short time. You would probably continue to pay those expenses that are fixed in the short run, such as house payments, car payments, and utility bills. You would still eat meals and put gas in the car but might give up see- ing new movies and buying new clothes. You might cut back a little on your food budget by eating out less, and spend less on other nonessentials. In the short run, you may have few options to cut spending. If your income fell permanently, however, you might decide to sell your house and car and move to smaller quarters or make other big changes in your consumption patterns. It is more difficult to argue that individuals will not increase their consumption in response to a temporary increase in income. But people will usually increase consumption less with a temporary increase in income than with a permanent increase. Thus the permanent income hypothesis seems to make good sense in terms of how people behave.

The permanent income hypothesis has some important implications for fiscal policy. If consumers fail to respond to a temporary increase in disposable income by spending a large fraction of it, then fiscal policy will have less effect on output. A temporary change

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CHAPTER 9Section 9.5 Limitations of Fiscal Policy

in government spending or taxes will still have a first-round effect on output and employ- ment, but subsequent (multiplier) changes in spending will be very small. Temporary changes in taxes or spending will have little impact on consumer spending because a one-time tax cut or a 1-year spending increase will affect permanent income much less than current income. For example, a person who expects to live 25 more years would not respond to a one-time tax cut of $1,000 as an increase in her permanent income of that amount. Ignoring interest, her permanent income increases by only $40 a year! Experi- ence supports this view. The 1964 and 1981 income tax cuts, which were enacted as per- manent changes, appear to have had more effect on income and consumption than the 1968 temporary surcharge or the 1975 one-time tax rebate. As part of the 2009 economic stimulus package, 130 million U.S. families and individuals received tax rebate checks from the Internal Revenue Service. Those $600 stimulus rebate checks were considered largely a bust by many economists because the recipients either put them in savings or paid credit card bills instead of spending them. Some economists insist that rebate checks are only a temporary solution to the problem and that more is needed to infuse a strug- gling economy.

Government Spending

Public choice economics attempts to integrate politics and economics by examining the motives and rewards for different types of behavior in the public sector. Economists in this tradition argue that fiscal policy actions tend to increase the size of the government sector relative to the private sector. (This is notwithstanding the timing issue; because the usual postwar business cycles last about six quarters and it could take longer for an administra- tion to first realize the recession, it may be too late to infuse the economy with tax rebate checks and other measures. By the time the spending is actually taking effect, the recession may be over.) James Buchanan—a Nobel Prize winner—and his col- league Richard Wagner see rising deficits and resistance to collecting the taxes to pay for spending as logical outcomes of the U.S. politi- cal system. Buchanan and Wag- ner (1977) have argued that poli- cies that hurt a few citizens very intensely and benefit most others very slightly are not likely to be enacted, even if the total benefits exceed the costs. Conversely, it is politically easy to enact programs that benefit a few greatly at a small cost to each taxpayer, even if total costs exceed total benefits.

Spending programs tend to benefit specific interest groups: defense firms, the automotive industry, welfare clients, hospitals, farm- ers, or industries that would like

Associated Press

Dairy cows stand in a field in Coventry, Vermont. In 2009, the Agriculture Department helped struggling dairy farmers by raising the price paid for milk and Cheddar cheese through a dairy price support program.

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CHAPTER 9Section 9.5 Limitations of Fiscal Policy

Policy Focus: The Council of Economic Advisers

At the end of World War II, political and business leaders feared that the transition from wartime to peacetime production would send the economy into another depression. In response to these con- cerns, Congress passed the Employment Act of 1946. The act reflected Keynesian ideas about the role of discretionary fiscal policy in keeping the economy on a steady path. This legislation made the U.S. government responsible for achieving and maintaining full employment, steady growth, and stable prices through the use of fiscal (and monetary) policy. To provide policy-making advice, Congress cre- ated the three-member Council of Economic Advisers.

Officially, the council’s three members, appointed by the president, are the chief economic-policy advis- ers. The functions of the council are to advise the president on the course of the economy and to par- ticipate in decision making on economic, budget, and financial policy, international as well as domestic (“About CEA,” n.d.). The president is also required (with the aid of the council) to prepare an annual economic report, the Economic Report of the President. This report, sent to Congress every January, describes the state of the economy and explains the administration’s policy decisions.

Some presidents rely heavily on the council for economic advice, while others depend more heavily on the secretary of the treasury or the director of the Office of Management and Budget. When Kennedy under- took the tax cut that was the most significant fiscal policy action of his administration, he acted on the advice and counsel of the chair of his Council of Economic Advisers, Walter Heller. Heller represented the ascendant Keynesian views of the 1950s and 1960s. He believed that it was possible to target a particular combination of inflation and unemployment and to structure expenditures, transfer payments, and taxes so as to achieve that target. He even gave this kind of policy a name: fine-tuning.

to export more. For example, an export subsidy may be designed to benefit the aircraft industry or soybean farmers. Such a policy benefits workers and owners in those indus- tries at the expense of domestic consumers of air travel or soybean products. The costs of many spending programs, such as farm price supports or cost overruns by defense contractors, are likewise borne by citizens in general as either higher current taxes, more inflation, or higher future taxes to finance deficits.

Keynesian economists, including Nobel Prize winner James Tobin, tend to be less con- cerned about the growth of government. They argue that the large size of the government sector relative to the private sector is a force for stability. Investment and net exports are quite unstable, as are some components of consumption—especially consumer durables. Government purchases, however, are quite stable from one year to the next. The share of total output that is bought by or produced by government is much larger now than it was in Keynes’s day. With this big, stable sector providing an anchor, the economy is less likely to drift into recession. These economists argue that the growing share of economic activity passing through government is the primary reason why there has not been another Great Depression.

Most economists would agree that it is inefficient to make production decisions through government when there are no compelling reasons such as public goods or strong exter- nalities. The market does a better job of allocating resources in response to consumer demand. Thus, if a larger share of economic activity in the public sector offers the benefit of greater stability, there will be a difficult trade-off between stability and efficiency.

(continued)

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CHAPTER 9Section 9.5 Limitations of Fiscal Policy

International Impact

An important limit to the effectiveness of fiscal policy is that much of the intended impact spills over to other nations. When a nation increases its output level, its citizens demand more imports. Imports are a leakage: Every extra dollar spent on imports instead of domes- tic goods reduces the multiplier effects of expansionary fiscal policy. In small countries, such as Guyana, Chad, Luxembourg, or Belgium, trade is a large share of total spending. In these countries, most of the impact of fiscal policy may spill abroad. Even for a nation like the United States, where imports are only about 17% of GDP, international spillovers can weaken the impact of fiscal policy.

Price-level changes represent another challenge to expansionary fiscal policy in an open economy. Expansionary policy shifts AD to the right, driving up the price level. With higher domestic prices, citizens want to buy more cheap foreign goods, while foreigners are less interested in the nation’s high-priced exports. The value of net exports (X 2 M) falls. There are fewer injections (X) and more leakages (M). A higher price level does even more than a higher level of income to offset the initial expansionary effect of fiscal policy. Prices affect both exports and imports, but rising real income only affects imports.

What about contractionary fiscal policy? Falling income reduces imports, while a falling price level will stimulate exports and reduce imports. Again, the effect of being part of a global economy is to offset some of the contractionary impact of fiscal policy.

Lags in Fiscal Policy

Lags in making policy decisions provide another limitation on discretionary fiscal pol- icy. The first lag is in identifying the problem. The recognition lag is the length of time required to become aware of, or recognize, an economic problem. Statistical measures (unemployment rate, consumer price index, and GDP) take from 1 to 3 months to com- pile. When these measures become available, they describe economic conditions for the previous month or previous quarter. These measures provide the basis for forecasting whether a recession will continue or end; whether unemployment will rise, fall, or remain the same; how fast output will grow; or what the rate of inflation will be. Such forecasts are difficult to make and prone to errors. An inaccurate forecast can result in the wrong fiscal policy.

Policy Focus: The Council of Economic Advisers (continued)

In 1993, President Clinton appointed the first woman to head the council, Laura D’Andrea Tyson of the University of California at Berkeley. Tyson was an unusual choice because her research work had been in areas other than macroeconomics. She favored higher taxes on the wealthy to reduce the deficit and more investment in education, training, and research. She also assisted Clinton on trade policy issues and reworking the government’s economic statistics to make them more accurate measures of the state of the economy. Under President Obama’s administration, the chair has most recently been filled by Alan Krueger.

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CHAPTER 9Section 9.5 Limitations of Fiscal Policy

Once a problem is recognized, more time passes as the president and Congress choose a fiscal policy solution and enact it into law. Policy makers must decide what kind of action to take—taxes, transfers, or government spending—and at what level. They must decide whose taxes to cut, what kinds of spending programs to undertake, and what section of the country should get the initial benefit. This implementation lag is the time it takes after a problem is recognized to choose and enact a fiscal policy in response.

After a fiscal policy has become law, further time passes before the economy improves. Tax changes can be implemented fairly quickly through payroll withholding, but most spending programs take time to design and carry out. Once the initial round of spending takes place, then the multiplier effects are felt over a period of 18 to 24 months. The impact lag is the time that elapses between the implementation of a fiscal policy and its full effect on economic activity.

Taken together, the recognition, implementation, and impact lags add up to a long period of time. It is quite possible that the combined lags can take up so much time that the full impact of a tax cut or an increase in spending will not be felt until after the economy has begun to move out of the recession by itself. In Figure 9.4, the points labeled R, I1, and I2 are, respectively, the end points of the recognition, implementation, and impact lags. As you can see, the delays mean that the policy’s effect on economic activity is not actually felt until the economy is well into the recovery phase. The dashed line from point I2 shows what the path of economic activity is likely to be as a result of poorly timed discretionary policy. The expansionary fiscal policy intended to combat recession may simply fuel infla- tion. Similar mistiming on contractionary policy could aggravate a recession. Discretion- ary fiscal policy combined with lags could actually make an economy less stable.

Figure 9.4: Lags and destabilizing fiscal policy

Recognition that the economy is in a recession occurs at Point R. Fiscal policy is implemented at I1, and its impact on the economy is finally felt at I2. Because the expansionary policy was delayed, the econ- omy takes on the course indicated by the dashed line rather than the solid line. Fiscal policy has made the economy less stable.

Time

Y

R

I 1

I 2

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CHAPTER 9Section 9.5 Limitations of Fiscal Policy

Key Ideas: Problems With Fiscal Policy

• Instability of the multiplier • Increase in the relative size of government • Impact of policy on other countries • Lags (recognition, implementation, and impact) • Political business cycles

The Political Business Cycle

Public choice economists have also suggested that fiscal policy combined with the U.S. political system can create a political business cycle. In many other countries, the politi- cal system is parliamentary. The legislative branch and executive branch are united under a prime minister. In such systems, the prime minister usually has some say about when elections are called, and campaigns are relatively brief. In the U.S. political system, how- ever, there are only 2 years between elections. All members of the House of Representa- tives and one third of the Senate are elected every 2 years, and presidents are elected every 4 years. Consequently, the next election is never very far from the mind of anyone in Congress or the White House.

The dominant party has a strong incentive to try to reduce unemployment and inflation so that economic conditions look good at the time of the next election. Such political maneu- vers give the economy a series of short-run policies and rapid reversals to meet political needs, rather than a consistent pursuit of long-run policies.

Some economists have suggested that politicians may control the business cycle so that it peaks just before elections. This political business cycle results from the use of fiscal (and monetary) policy to influence the outcome of elections. A downturn can follow an elec- tion, as long as there is another peak, or at least an upturn, in time for the next election. According to this view, the level and timing of tax and spending changes (and, when the Federal Reserve is willing to cooperate, changes in the money supply) tend to respond less to changes in economic activity than to the timing of elections.

Economist Douglas A. Hibbs, Jr., offered evidence (1989) that favorable or unfavorable economic conditions at the time of an election have a definite effect on the success or fail- ure of the incumbent party. People tend to place blame on our leaders for economic condi- tions even when those leaders are not responsible. For example, President Reagan saw his party lose many congressional seats in the recession-year election of 1982. Economic con- ditions had improved by the 1984 presidential election, no doubt contributing to Reagan’s landslide reelection. Although economic conditions can influence political outcomes, thus far no economist has been able to show that politicians are actually able to create a politi- cal business cycle for their own benefit.

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CHAPTER 9Post-Test

Conclusion

Five decades of largely expansionary fiscal actions, whether aimed at stimulating output or responding to other pressures, have resulted in a large budget deficit. This problem of fiscal policy is a major focus of public debate. The official title of the American Recovery and Reinvestment Act of 2009 is “An act making supplemental appropriations for job preservation and creation, infrastructure investment, energy effi- ciency and science, assistance to the unemployed, State, and local fiscal stabilization, for the fiscal year ending September 30, 2009, and for other purposes.” Quite a title, isn’t it? But did it come close to accomplishing all of those goals? Does the economy of 2012 still fit the traditional model of Keynesian expansionary fiscal policy? Are the rebate checks and corporate bailouts helping policies shift aggregate demand and supply to the right?

The analysis of fiscal policy in this chapter has used the aggregate expenditure (Keynes- ian) model with a fixed price level. When the price level can change, this simple Keynes- ian model needs to be blended with the model of aggregate supply and demand. For most of this chapter, we have concentrated on expansionary fiscal policy. Contractionary fiscal policy like higher taxes, lower transfers, or reduced government spending is rarely undertaken, and usually only in response to severe inflation. Contractionary fiscal policy affects both real output and the price level. Which of the two is affected more depends on the range of the aggregate supply curve in which the economy is operating.

The policies of the early 2000s have contributed to the growing budget deficit, the most hotly debated macroeconomic issue of the new century. We will address that issue in the next chapter.

Post-Test

1. The use of fiscal policy to stabilize output is a. supported by economists in the classical tradition and opposed by Keynesians. b. opposed by economists in the classical tradition and supported by Keynesians. c. supported by economists in both the classical and Keynesian traditions. d. opposed by economists in both the classical and Keynesian traditions.

2. Which of the following is least sensitive to any direct manipulation by the government?

a. consumption spending b. investment spending c. spending on imports d. spending on transfer payments e. spending on defense

3. Which of the following is an element of the Keynesian argument that govern- ment should use fiscal policy to intervene in the economy?

a. Only the private sector can be counted on to act in the social interest. b. Macroeconomic equilibrium does not ensure that the economy will have full

employment with price stability. c. In a capitalistic economy, the private sector is a source of economic stability. d. Only the public sector acting in the social interest is part of the Keynesian

argument for fiscal policy.

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CHAPTER 9Post-Test

4. Which of the following is least likely to influence spending on net exports? a. import subsidies b. tariffs c. quotas d. a lower price for the country’s currency e. an investment tax credit

5. The largest item of state and local government spending is a. education. b. income security. c. transportation. d. public safety. e. health care.

6. Which of the following is NOT an automatic stabilizer? a. income taxes b. unemployment compensation c. imports d. Social Security benefits e. defense spending

7. The Employment Act of 1946 a. made the U.S. government responsible for achieving and maintaining full

Social Security benefits. b. identified specific behavior and targets for the conduct of U.S. foreign-aid

policy. d. set the goals for the U.S. economy as 4% unemployment and 3% inflation. d. made the U.S. government responsible for achieving and maintaining full

employment.

8. The Johnson tax surcharge was an example of a. expansionary fiscal policy. b. an automatic stabilizer. c. a supply side policy. d. a political business cycle. e. contractionary fiscal policy.

9. After the Kennedy tax cut in 1964, a. the unemployment rate fell and the economic growth rate increased. b. the inflation rate increased and unemployment was unchanged. c. the rate of economic growth was unchanged but unemployment fell. d. there was a budget surplus.

10. According to the permanent income hypothesis, a. income is more stable than consumption. b. income is more stable than investment. c. consumption is more stable than investment. d. consumption is more stable than income. e. current income is the most important determinant of consumption.

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CHAPTER 9Key Ideas

Answers 1. b. opposed by economists in the classical tradition and supported by Keynesians. The answer can be

found in Section 9.1. 2. b. investment spending. The answer can be found in Section 9.1. 3. b. Macroeconomic equilibrium does not ensure that the economy will have full employment with

price stability. The answer can be found in Section 9.2. 4. e. an investment tax credit. The answer can be found in Section 9.2. 5. a. education. The answer can be found in Section 9.3. 6. e. defense spending. The answer can be found in Section 9.3. 7. d. made the U.S. government responsible for achieving and maintaining full employment. The answer

can be found in Section 9.4. 8. e. contractionary fiscal policy. The answer can be found in Section 9.4. 9. a. the unemployment rate fell and the economic growth rate increased. The answer can be found in

Section 9.5. 10. d. consumption is more stable than income. The answer can be found in Section 9.5.

Key Ideas

1. Keynesian fiscal policy is based on three assumptions: (a) The economy can be in equilibrium with either high unemployment or inflation. (b) Changes in private or foreign-sector spending may result in an equilibrium that is not satisfactory. (c) Only the government can be counted on to change its spending and taxing to move the economy toward a more acceptable equilibrium. A recessionary gap occurs when aggregate expenditure is too low to purchase an economy’s full- employment output. Fiscal policy can be used to close a recessionary gap.

2. An appropriate fiscal policy in a recession would be a reduction in taxes or an increase in government spending and transfer payments. An appropriate fiscal policy in an economy with low unemployment and high inflation would be the opposite. A careful design of the mix of changes in taxes and spending can also shift aggregate supply to the right.

3. Automatic stabilizers reduce fluctuations in economic activity without requiring legislation. Discretionary fiscal policy requires deliberate action by the executive branch or by Congress.

4. Major examples of discretionary fiscal policy in the United States were the Ken- nedy tax cut, the Ford tax rebate, and the Johnson tax surcharge. The Reagan tax cut, the Bush and Clinton deficit reduction actions, the Bush tax cut, and the Bush and Obama deficit-reduction actions can also be analyzed as discretionary fiscal policy.

5. The permanent income hypothesis says that consumption is based on permanent income and income expectations, not just current income. By this hypothesis, the Keynesian expenditure multiplier is unstable and fiscal policy is less effec- tive. Public choice economists argue that active fiscal policy leads to inefficiency because it results in a larger public sector and creates an opportunity for politi- cal business cycles. International spillovers reduce the domestic impact of fiscal policy. Discretionary fiscal policy is also limited by lags in recognition, imple- mentation, and impact.

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CHAPTER 9Critical Thinking Questions

Critical Thinking Questions

1. Why did Keynes not expect the private sector to offer much help in stabilizing economic activity?

2. What are the costs and benefits of having a larger government sector and a smaller private sector?

3. How does the permanent income hypothesis challenge the effectiveness of fiscal policy?

4. Why is fiscal policy less effective in an economy with a large foreign sector? 5. Why does a tax cut have less effect on the level of income and output than

an equal change in government spending? What about a change in transfer payments?

6. Do you think that economists who adhere to classical macroeconomic theory would recommend the use of fiscal policy to eliminate a recessionary gap? Why or why not?

7. How would you identify a political business cycle? 8. Under what conditions will expansionary fiscal policy be inflationary? 9. Suppose MPC 5 0.9, C0 5 $300 billion, and I, G, T, and (X 2 M) are each equal to

$100 billion. What are the equilibrium values of Y, C, and S? 10. If G in Question 9 rises to $150 billion, ceteris paribus, by how much will the

equilibrium levels of Y, C, and S change? What will happen to the equilibrium levels of Y, C, and S if T were reduced by $50 billion, ceteris paribus?

11. Use the information in Question 9 and suppose that Y* is $5,600 billion. By how much would G have to change to bring the economy to full employment? By how much would T have to change?

12 According to the permanent income hypothesis, which of the following would have the greatest effect on your consumption? Why?

a. an annual bonus b. a promotion c. a 6-week layoff d. a marriage to someone who is also employed

13. Classify each of the following as a recognition, implementation, or impact lag: a. The numbers on GDP are slow in arriving from the Department of Commerce. b. Congress takes a recess to think things over. c. A new spending program has finally been put in place, and the dollars are

starting to trickle through the economy. 14. If the United States changed its political system so that elections were held less

often and called by the president at a time that he or she chose, how do you think macroeconomic policy would be affected?

15. Why are economists concerned about the lags associated with fiscal policy actions? What solutions can you suggest?

16. Using the latest Economic Report of the President, list the rates of unemployment, inflation, and real output growth since 2001, the year of the Bush tax cut. What conclusions can you draw about possible effects of that tax cut as expansionary fiscal policy?

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