C H A P T E R 10 Fiscal Policy Copyright © 2012 Pearson Prentice Hall All rights reserved Copyright © 2012 Pearson Prentice Hall All rights reserved 10-1 CHAPTER Fiscal Policy 10 As President Obama’s administration began in January 2009, the economy was in the midst of a very severe recession PREPARED BY Copyright © 2012 Pearson Prentice Hall All rights reserved Brock Williams C H A P T E R 10 Fiscal Policy APPLYING THE CONCEPTS Why are the United States and many other countries facing dramatically increasing costs for their government programs? Increasing Life Expectancy and Aging Populations Spur Costs of Entitlement Programs How are tax rates and tax revenues related? The Confucius Curve? Did President Obama’s fiscal stimulus work as expected? Evaluating the Obama Fiscal Stimulus Copyright © 2012 Pearson Prentice Hall All rights reserved 10-3 C H A P T E R 10 Fiscal Policy Fiscal Policy ● fiscal policy Changes in government taxes and spending that affect the level of GDP Copyright © 2012 Pearson Prentice Hall All rights reserved 10-4 C H A P T E R 10 Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY Fiscal Policy and Aggregate Demand FIGURE 10.1 Fiscal Policy in Action Panel A shows that an increase in government spending shifts the aggregate demand curve from AD0 to AD1, restoring the economy to full employment This is an example of expansionary policy Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD to AD1, restoring the economy to full employment This is an example of contractionary policy Copyright © 2012 Pearson Prentice Hall All rights reserved 10-5 C H A P T E R 10 Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY (cont’d) Fiscal Policy and Aggregate Demand ● expansionary policies Government policy actions that lead to increases in aggregate demand ● contractionary policies Government policy actions that lead to decreases in aggregate demand Copyright © 2012 Pearson Prentice Hall All rights reserved 10-6 C H A P T E R 10 Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY (cont’d) The Fiscal Multiplier •As the government develops policies to stabilize the economy, it needs to take the multiplier into account •The total shift in aggregate demand will be larger than the initial shift As we will see later in this chapter, •U.S policymakers have taken the multiplier into account as they have developed policies for the economy The Limits to Stabilization Policy ● stabilization policies Policy actions taken to move the economy closer to full employment or potential output Copyright © 2012 Pearson Prentice Hall All rights reserved 10-7 C H A P T E R 10 Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY (cont’d) The Limits to Stabilization Policy LAGS ● inside lags The time it takes to formulate a policy ● outside lags The time it takes for the policy to actually work FORECASTING UNCERTAINTIES What makes the problem of lags even worse is that economists are not very accurate in forecasting what will happen in the economy Copyright © 2012 Pearson Prentice Hall All rights reserved 10-8 C H A P T E R 10 Fiscal Policy LAGS 10.1 THE ROLE OF FISCAL POLICY (cont’d) The Limits to Stabilization Policy FIGURE 10.2 Possible Pitfalls in Stabilization Policy Panel A shows an example of successful stabilization policy The solid line represents the behavior of GDP in the absence of policies The dashed line shows the behavior of GDP when policies are in place Successfully timed policies help smooth out economic fluctuations Panel B shows the consequences of illtimed policies Again, the solid line shows GDP in the absence of policies and the dashed line shows GDP with policies in place Notice how ill-timed policies make economic fluctuations greater Copyright © 2012 Pearson Prentice Hall All rights reserved 10-9 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET Federal Spending Copyright © 2012 Pearson Prentice Hall All rights reserved 10-10 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d) Federal Spending ● discretionary spending The spending programs that Congress authorizes on an annual basis ● entitlement and mandatory spending Spending that Congress has authorized by prior law, primarily providing support for individuals Copyright © 2012 Pearson Prentice Hall All rights reserved 10-11 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d) Federal Spending ● Social Security A federal government program to provide retirement support and a host of other benefits ● Medicare A federal government health program for the elderly ● Medicaid A federal and state government health program for the poor Copyright © 2012 Pearson Prentice Hall All rights reserved 10-12 C H A P T E R 10 Fiscal Policy APPLICATION INCREASING LIFE EXPECTANCY AND AGING POPULATIONS SPUR COSTS OF ENTITLEMENT PROGRAMS APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing costs for their government programs? • Today, Social Security, Medicare, and Medicaid constitute approximately 10 percent of GDP • Experts estimate that in 2075 spending on these programs will be approximately 22 percent of GDP How will our society cope with increased demands for these services? Possible solutions: • Leave the existing programs in place and just raise taxes to pay for them • The government should save and invest now to increase GDP in the future to reduce the burden on future generations • Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being • Reform the health-care system to encourage more competition to reduce health-care expenditures Copyright © 2012 Pearson Prentice Hall All rights reserved 10-13 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d) Federal Revenues Copyright © 2012 Pearson Prentice Hall All rights reserved 10-14 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d) Federal Revenues SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE ● supply-side economics A school of thought that emphasizes the role that taxes play in the supply of output in the economy ● Laffer curve A relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax revenues if economic activity is severely discouraged Copyright © 2012 Pearson Prentice Hall All rights reserved 10-15 C H A P T E R 10 Fiscal Policy APPLICATION THE CONFUCIUS CURVE? APPLYING THE CONCEPTS #2: How are tax rates and tax revenues related? •While the idea that cutting tax rates might actually increase tax revenue is often attributed to economist Arthur Laffer, in fact, it is actually a much older idea than that •Yu Juo, one of the twelve wise men who succeeded Confucius in ancient China, was asked what should be done in the case of a famine if the government had insufficient funds He replied that the tax rate should be cut to 10 percent Skeptical government bureaucrats did not have enough funds at a 20 percent rate, so how could they cut it to 10 percent? •Yu Juo replied, “Cutting taxes and limiting your expenses allow people to raise their standard of living Afterwards, you will no longer need to worry about famine and shortage.” •Revenue estimators in Washington, D.C, not share entirely in Yu Juo’s wisdom, but they recognize that cutting tax rates will stimulate economic activity Copyright © 2012 Pearson Prentice Hall All rights reserved 10-16 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d) The Federal Deficit and Fiscal Policy ● budget deficit The amount by which government spending exceeds revenues in a given year ● budget surplus The amount by which government revenues exceed government expenditures in a given year Copyright © 2012 Pearson Prentice Hall All rights reserved 10-17 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d) Automatic Stabilizers The increased federal budget deficit works through three channels: Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income Because incomes not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much Because the corporation tax depends on corporate profits and profits fall in a recession, taxes on businesses also fall Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession ● automatic stabilizers Taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit action Copyright © 2012 Pearson Prentice Hall All rights reserved 10-18 C H A P T E R 10 Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d) Are Deficits Bad? No – Automatic Stabilizers Yes – Crowding Out PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it Copyright © 2012 Pearson Prentice Hall All rights reserved 10-19 C H A P T E R 10 Fiscal Policy 10.3 FISCAL POLICY IN U.S HISTORY The Depression Era During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits According to Brown, fiscal policy was expansionary only during two years of the Great Depression, 1931 and 1936 The Kennedy Administration Although modern fiscal policy was not deliberately used during the 1930s, the growth in military spending at the onset of World War II in 1941 increased total demand in the economy and helped pull the economy out of its long decade of poor performance But to see fiscal policy in action, we need to turn to the 1960s It was not until the presidency of John F Kennedy during the early 1960s that modern fiscal policy came to be accepted Copyright © 2012 Pearson Prentice Hall All rights reserved 10-20 C H A P T E R 10 Fiscal Policy 10.3 FISCAL POLICY IN U.S HISTORY (cont’d) The Vietnam War Era ● permanent income An estimate of a household’s long-run average level of income The Reagan Administration The tax cuts enacted during 1981 at the beginning of the first term of President Ronald Reagan were significant However, they were not proposed to increase aggregate demand Instead, the tax cuts were justified on the basis of improving economic incentives and increasing the supply of output Copyright © 2012 Pearson Prentice Hall All rights reserved 10-21 C H A P T E R 10 Fiscal Policy 10.3 FISCAL POLICY IN U.S HISTORY (cont’d) The Clinton and George W Bush Administrations FIGURE 10.3 Federal Taxes, Spending, and Deficits, 1996–2009 Copyright © 2012 Pearson Prentice Hall All rights reserved In late 1990’s, tax increases, limited government spending, and economic growth which increased revenues resulted in the U.S experienced a surplus Tax cuts and stimulus packages designed to stimulate the economy after the recessions of 2001 and 2008 resulted in U.S deficits again 10-22 C H A P T E R 10 Fiscal Policy APPLICATION EVALUATING THE OBAMA FISCAL STIMULUS APPLYING THE CONCEPTS #3: Did President Obama’s fiscal stimulus work as expected? •The Council of Economic Advisors was required to determine the effectiveness of the stimulus package and make regular reports to Congress •They determined that employment and growth were higher in the second and third quarter of 2009 than would have been expected, but could not be sure the stimulus package was the cause •Using conventional models and comparisons with other countries, the council determined that the package avoided the loss about one million jobs •However, unemployment was still almost 10 percent and high unemployment will linger for years •Even if there was a positive effect, the lingering effect of the recession would still be painful Copyright © 2012 Pearson Prentice Hall All rights reserved 10-23 C H A P T E R 10 Fiscal Policy KEY TERMS automatic stabilizers Laffer curve budget deficit Medicaid budget surplus Medicare contractionary policies outside lags discretionary spending permanent income entitlement and mandatory spending Social Security expansionary policies stabilization policies fiscal policy supply-side economics inside lags Copyright © 2012 Pearson Prentice Hall All rights reserved 10-24 ... Pearson Prentice Hall All rights reserved 10- 4 C H A P T E R 10 Fiscal Policy 10. 1 THE ROLE OF FISCAL POLICY Fiscal Policy and Aggregate Demand FIGURE 10. 1 Fiscal Policy in Action Panel A shows... 10- 9 C H A P T E R 10 Fiscal Policy 10. 2 THE FEDERAL BUDGET Federal Spending Copyright © 2012 Pearson Prentice Hall All rights reserved 10- 10 C H A P T E R 10 Fiscal Policy 10. 2 THE FEDERAL BUDGET... reserved 10- 13 C H A P T E R 10 Fiscal Policy 10. 2 THE FEDERAL BUDGET (cont’d) Federal Revenues Copyright © 2012 Pearson Prentice Hall All rights reserved 10- 14 C H A P T E R 10 Fiscal Policy 10. 2