Chapter13
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Chapter13

Course Number: ECON 131, Spring 2013

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Chapter13: Fiscal Policy, Deficits, and Debt Chapter Opener p. 257 AFTER READING THIS CHAPTER, YOU SHOULD BE ABLE TO: 1 Identify and explain the purposes, tools, and limitations of fiscal policy. 2 Explain the role of built-in stabilizers in moderating business cycles. 3 Describe how the cyclically adjusted budget reveals the status of U.S. fiscal policy. 4 Discuss the size, composition, and consequences...

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Fiscal Chapter13: Policy, Deficits, and Debt Chapter Opener p. 257 AFTER READING THIS CHAPTER, YOU SHOULD BE ABLE TO: 1 Identify and explain the purposes, tools, and limitations of fiscal policy. 2 Explain the role of built-in stabilizers in moderating business cycles. 3 Describe how the cyclically adjusted budget reveals the status of U.S. fiscal policy. 4 Discuss the size, composition, and consequences of the U.S. public debt. ORIGIN OF THE IDEA O 13.1 Fiscal policy In the previous chapter we saw that an excessive increase in aggregate demand can cause demand-pull inflation and that a significant decline in aggregate demand can cause recession and cyclical unemployment. For these reasons, the Federal government sometimes uses budgetary actions to try to stimulate the economy or rein in inflation. Such countercyclical fiscal policyChanges in government spending and tax collections designed to achieve a full-employment and noninflationary domestic output; also called discretionary fiscal policy. consists of deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth. (The adjective fiscal simply means financial.) We begin this chapter by examining the logic behind fiscal policy, its current status, and its limitations. Then we examine a closely related topic: the U.S. public debt. Our discussion of fiscal policy and public debt is very timely. In 2009, Congress and the Obama administration began a $787 billion stimulus program designed to help lift the U.S. economy out of deep recession. This fiscal policy contributed to a $1.4 trillion Federal budget deficit in 2009, which increased the size of the U.S. public debt to $11.9 trillion. Fiscal Policy and the AD-AS Model p. 258 The fiscal policy just defined is discretionary (or active). It is often initiated on the advice of the president's Council of Economic Advisers (CEA) A group of three persons that advises and assists the president of the United States on economic matters (including the preparation of the annual Economic Report of the President)., a group of three economists appointed by the president to provide expertise and assistance on economic matters. Discretionary changes in government spending and taxes are at the option of the Federal government. They do not occur automatically. Changes that occur without congressional action are nondiscretionary (or passive or automatic), and we will examine them later in this chapter. Expansionary Fiscal Policy When recession occurs, an expansionary fiscal policyAn increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output. may be in order. This policy consists of government spending increases, tax reductions, or both, designed to increase aggregate demand and therefore raise real GDP. Consider Figure 13.1, where we suppose that a sharp decline in investment spending has shifted the economy's aggregate demand curve to the left from AD 1 to AD2. (Disregard the arrows and dashed downsloping line for now.) The cause of the recession may be that profit expectations on investment projects have dimmed, curtailing investment spending and reducing aggregate demand. FIGURE 13.1 Expansionary fiscal policy. Expansionary fiscal policy uses increases in government spending or tax cuts to push the economy out of recession. In an economy with an MPC of .75, a $5 billion increase in government spending or a $6.67 billion decrease in personal taxes (producing a $5 billion initial increase in consumption) expands aggregate demand from AD 2 to the downsloping dashed curve. The multiplier then magnifies this initial increase in spending to AD 1. So real GDP rises along the broken horizontal line by $20 billion. Suppose the economy's potential or full-employment output is $510 billion in Figure 13.1. If the price level is inflexible downward at P1, the broken horizontal line becomes relevant to the analysis. The aggregate demand curve moves leftward and reduces real GDP from $510 billion to $490 billion. A negative GDP gap of $20 billion (= $490 billion $510 billion) arises. An increase in unemployment accompanies this negative GDP gap because fewer workers are needed to produce the reduced output. In short, the economy depicted is suffering both recession and cyclical unemployment. What fiscal policy should the Federal government adopt to try to stimulate the economy? It has three main options: (1) increase government spending, (2) reduce taxes, or (3) use some combination of the two. If the Federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficitThe amount by which the expenditures of the Federal government exceed its revenues in any year.government spending in excess of tax revenues. Increased Government Spending Other things equal, a sufficient increase in government spending will shift an economy's aggregate demand curve to the right, from AD2 to AD1 in Figure 13.1. To see why, suppose that the recession prompts the government to initiate $5 billion of new spending on highways, education, and health care. We represent this new $5 billion of government spending as the horizontal distance between AD 2 and the dashed downsloping line immediately to its right. At each price level, the amount of real output that is demanded is now $5 billion greater than that demanded before the expansion of government spending. But the initial increase in aggregate demand is not the end of the story. Through the multiplier effect, the aggregate demand curve shifts to AD 1, a distance that exceeds that represented by the originating $5 billion increase in government purchases. This greater shift occurs because the multiplier process magnifies the initial change in spending into successive rounds of new consumption spending. If the economy's MPC is .75, then the simple multiplier is 4. So the aggregate demand curve shifts rightward by four times the distance between AD2 and the broken downsloping line. Because this particular increase in aggregate demand occurs along the horizontal brokenline segment, real output rises by the full extent of the multiplier. Observe that real output rises to $510 billion, up $20 billion from its recessionary level of $490 billion. Concurrently, unemployment falls as firms increase their employment to the full-employment level that existed before the recession. p. 259 Tax Reductions Alternatively, the government could reduce taxes to shift the aggregate demand curve rightward, as from AD 2 to AD1. Suppose the government cuts personal income taxes by $6.67 billion, which increases disposable income by the same amount. Consumption will rise by $5 billion (= MPC of .75 $6.67 billion) and saving will go up by $1.67 billion (= MPS of . 25 $6.67 billion). In this case the horizontal distance between AD 2 and the dashed downsloping line in Figure 13.1 represents only the $5 billion initial increase in consumption spending. Again, we call it initial consumption spending because the multiplier process yields successive rounds of increased consumption spending. The aggregate demand curve eventually shifts rightward by four times the $5 billion initial increase in consumption produced by the tax cut. Real GDP rises by $20 billion, from $490 billion to $510 billion, implying a multiplier of 4. Employment increases accordingly. You may have noted that a tax cut must be somewhat larger than the proposed increase in government spending if it is to achieve the same amount of rightward shift in the aggregate demand curve. This is because part of a tax reduction increases saving, rather than consumption. To increase initial consumption by a specific amount, the government must reduce taxes by more than that amount. With an MPC of .75, taxes must fall by $6.67 billion for $5 billion of new consumption to be forthcoming because $1.67 billion is saved (not consumed). If the MPC had instead been, say, .6, an $8.33 billion reduction in tax collections would have been necessary to increase initial consumption by $5 billion. The smaller the MPC, the greater the tax cut needed to accomplish a specific initial increase in consumption and a specific shift in the aggregate demand curve. Combined Government Spending Increases and Tax Reductions The government may combine spending increases and tax cuts to produce the desired initial increase in spending and the eventual increase in aggregate demand and real GDP. In the economy depicted in Figure 13.1, the government might increase its spending by $1.25 billion while reducing taxes by $5 billion. As an exercise, you should explain why this combination will produce the targeted $5 billion initial increase in new spending. If you were assigned Chapter 11, think through these three fiscal policy options in terms of the recessionary-expenditure-gap analysis associated with the aggregate expenditures model (Figure 11.7). And recall from the appendix to Chapter 12 that rightward shifts of the aggregate demand curve relate directly to upward shifts of the aggregate expenditures schedule. Contractionary Fiscal Policy When demand-pull inflation occurs, a restrictive or contractionary fiscal policyA decrease in government purchases of goods and services, an increase in net taxes, or some combination of the two, for the purpose of decreasing aggregate demand and thus controlling inflation. may help control it. This policy consists of government spending reductions, tax increases, or both, designed to decrease aggregate demand and therefore lower or eliminate inflation. Look at Figure 13.2, where the full-employment level of real GDP is $510 billion. The economy starts at equilibrium at point a, where the initial aggregate demand curve AD3 intersects aggregate supply curve AS. Suppose that after going through the multiplier process, a $5 billion initial increase in investment and net export spending shifts the aggregate demand curve to the right by $20 billion, from AD3 to AD4. (Ignore the downsloping dashed line for now.) Given the upsloping AS curve, however, the equilibrium GDP does not rise by the full $20 billion. It only rises by $12 billion, to $522 billion, thereby creating an inflationary GDP gap of $12 billion ($522 billion $510 billion). The upslope of the AS curve means that some of the rightward movement of the AD curve ends up causing demand-pull inflation rather than increased output. As a result, the price level rises from P1 to P2 and the equilibrium moves to point b. FIGURE 13.2 Contractionary fiscal policy. Contractionary fiscal policy uses decreases in government spending, increases in taxes, or both, to reduce demand-pull inflation. Here, an increase in aggregate demand from AD 3 to AD4 has driven the economy to point b and ratcheted the price level up to P2, where it becomes inflexible downward. If the economy's MPC is .75 and the multiplier therefore is 4, the government can either reduce its spending by $3 billion or increase its taxes by $4 billion (which will decrease consumption by $3 billion) to eliminate the inflationary GDP gap of $12 billion (= $522 billion $510 billion). Aggregate demand will shift leftward, first from AD4 to the dashed downsloping curve to its left, and then to AD 5. With the price level remaining at P2, the economy will move from point b to point c and the inflationary GDP gap will disappear. p. 260 Without a government response, the inflationary GDP gap will cause further inflation (as input prices rise in the long run to meet the increase in output prices). If the government looks to fiscal policy to eliminate the inflationary GDP gap, its options are the opposite of those used to combat recession. It can (1) decrease government spending, (2) raise taxes, or (3) use some combination of those two policies. When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus The amount by which the revenues of the Federal government exceed its expenditures in any year.tax revenues in excess of government spending. But before discussing how the government can either decrease government spending or increase taxes to move toward a government budget surplus and control inflation, we have to keep in mind that the price level is like a ratchet. While increases in aggregate demand that expand real output beyond the fullemployment level tend to ratchet the price level upward, declines in aggregate demand do not seem to push the price level downward. This means that stopping inflation is a matter of halting the rise of the price level, not trying to lower it to the previous level. It also means that the government must take the ratchet effect into account when deciding how big a cut in spending or an increase in taxes it should undertake. Decreased Government Spending To control demand-pull inflation, the government can decrease aggregate demand by reducing government spending. To see why the ratchet effect matters so much, look at Figure 13.2 and consider what would happen if the government ignored the ratchet effect and attempted to design a spending-reduction policy to eliminate the inflationary GDP gap. Since the $12 billion gap was caused by the $20 billion rightward movement of the aggregate demand curve from AD 3 to AD4, the government might naively think that it could solve the problem by causing a $20 billion leftward shift of the aggregate demand curve to move it back to where it originally was. It could attempt to do so by reducing government spending by $5 billion and then allowing the multiplier effect to expand that initial decrease into a $20 billion decline in aggregate demand. That would shift the aggregate demand curve leftward by $20 billion, putting it back at AD3. This policy would work fine if there were no ratchet effect and if prices were flexible. The economy's equilibrium would move back from point b to point a, with equilibrium GDP returning to the full-employment level of $510 billion and the price level falling from P2 back to P1. But because there is a ratchet effect, this scenario is not what will actually happen. Instead, the ratchet effect implies that the price level is stuck at P2, so that the broken horizontal line at price level P2 becomes important to the analysis. The fixed price level means that when the government reduces spending by $5 billion to shift the aggregate demand curve back to AD 3, it will actually cause a recession! The new equilibrium will not be at point a. It will be at point d, where aggregate demand curve AD3 crosses the broken horizontal line. At point d, real GDP is only $502 billion, $8 billion below the fullemployment level of $510 billion. The problem is that, with the price level downwardly inflexible at P2, the $20 billion leftward shift of the aggregate demand curve causes a full $20 billion decline in real GDP. None of the change in aggregate demand can be dissipated as a decline in the price level. As a result, equilibrium GDP declines by the full $20 billion, falling from $522 billion to $502 billion and putting it $8 billion below potential output. By not taking the ratchet effect into account, the government has overdone the decrease in government spending, replacing a $12 billion inflationary GDP gap with an $8 billion recessionary GDP gap. This is clearly not what it had in mind. Here's how it can avoid this scenario. First, the government takes account of the size of the inflationary GDP gap. It is $12 billion. Second, it knows that with the price level fixed, the multiplier will be in full effect. Thus, it knows that any decline in government spending will be multiplied by a factor of 4. It then reasons that government spending will have to decline by only $3 billion rather than $5 billion. Why? Because the $3 billion initial decline in government spending will be multiplied by 4, creating a $12 billion decline in aggregate demand. Under the circumstances, a $3 billion decline in government spending is the correct amount to exactly offset the $12 billion GDP gap. This inflationary GDP gap is the problem that government wants to eliminate. To succeed, it need not undo the full increase in aggregate demand that caused the inflation in the first place. Graphically, the horizontal distance between AD 4 and the dashed downsloping line to its left represents the $3 billion decrease in government spending. Once the multiplier process is complete, this spending cut will shift the aggregate demand curve leftward from AD 4 to AD5. With the price level fixed at P2, the economy will come to equilibrium at point c. The economy will operate at its potential output of $510 billion, and the inflationary GDP gap will be eliminated. Furthermore, because the government took the ratchet effect correctly into account, the government will not accidentally push the economy into a recession by making an overly large initial decrease in government spending. p. 261 Increased Taxes Just as government can use tax cuts to increase consumption spending, it can use tax increases to reduce consumption spending. If the economy in Figure 13.2 has an MPC of .75, the government must raise taxes by $4 billion to achieve its fiscal policy objective. The $4 billion tax increase reduces saving by $1 billion (= the MPS of .25 $4 billion). This $1 billion reduction in saving, by definition, is not a reduction in spending. But the $4 billion tax increase also reduces consumption spending by $3 billion (= the MPC of .75 $4 billion), as shown by the distance between AD 4 and the dashed downsloping line to its left in Figure 13.2. After the multiplier process is complete, this initial $3 billion decline in consumption will cause aggregate demand to shift leftward by $12 billion at each price level (multiplier of 4 $3 billion). With the economy moving to point c, the inflationary GDP gap will be closed and the inflation will be halted. INTERACTIVE GRAPHS G 13.1 Fiscal policy Combined Government Spending Decreases and Tax Increases The government may choose to combine spending decreases and tax increases in order to reduce aggregate demand and check inflation. To check your understanding, determine why a $1.5 billion decline in government spending combined with a $2 billion increase in taxes would shift the aggregate demand curve from AD4 to AD5. Also, if you were assigned Chapter 11, explain the three fiscal policy options for fighting inflation by referring to the inflationaryexpenditure-gap concept developed with the aggregate expenditures model (Figure 11.7). And recall from the appendix to Chapter 12 that leftward shifts of the aggregate demand curve are associated with downshifts of the aggregate expenditures schedule. Policy Options: G or T? Which is preferable as a means of eliminating recession and inflation? The use of government spending or the use of taxes? The answer depends largely on one's view as to whether the government is too large or too small. Economists who believe there are many unmet social and infrastructure needs usually recommend that government spending be increased during recessions. In times of demand-pull inflation, they usually recommend tax increases. Both actions either expand or preserve the size of government. Economists who think that the government is too large and inefficient usually advocate tax cuts during recessions and cuts in government spending during times of demand-pull inflation. Both actions either restrain the growth of government or reduce its size. The point is that discretionary fiscal policy designed to stabilize the economy can be associated with either an expanding government or a contracting government. QUICK REVIEW 13.1 Discretionary fiscal policy is the purposeful change of government expenditures and tax collections by government to promote full employment, price stability, and economic growth. Expansionary fiscal policy consists of increases in government spending, reductions in taxes, or both, and is designed to expand real GDP by increasing aggregate demand. Contractionary fiscal policy entails decreases in government spending, increases in taxes, or both, and is designed to reduce aggregate demand and slow or halt demand-pull inflation. To be implemented correctly, contractionary fiscal policy must properly account for the ratchet effect and the fact that the price level will not fall as the government shifts the aggregate demand curve leftward. Built-In Stability To some degree, government tax revenues change automatically over the course of the business cycle and in ways that stabilize the economy. This automatic response, or built-in stability, constitutes nondiscretionary (or passive or automatic) budgetary policy and results from the makeup of most tax systems. We did not include this built-in stability in our discussion of fiscal policy over the last few pages because we implicitly assumed that the same amount of tax revenue was being collected at each level of GDP. But the actual U.S. tax system is such that net tax revenues vary directly with GDP. (Net taxes are tax revenues less transfers and subsidies. From here on, we will use the simpler taxes to mean net taxes.) p. 262 Virtually any tax will yield more tax revenue as GDP rises. In particular, personal income taxes have progressive rates and thus generate more-thanproportionate increases in tax revenues as GDP expands. Furthermore, as GDP rises and more goods and services are purchased, revenues from corporate income taxes and from sales taxes and excise taxes also increase. And, similarly, revenues from payroll taxes rise as economic expansion creates more jobs. Conversely, when GDP declines, tax receipts from all these sources also decline. Transfer payments (or negative taxes) behave in the opposite way from tax revenues. Unemployment compensation payments and welfare payments decrease during economic expansion and increase during economic contraction. Automatic or Built-In Stabilizers A built-in stabilizerA mechanism that increases government's budget deficit (or reduces its surplus) during a recession and increases government's budget surplus (or reduces its deficit) during an expansion without any action by policymakers. The tax system is one such mechanism. is anything that increases the government's budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policymakers. As Figure 13.3 reveals, this is precisely what the U.S. tax system does. Government expenditures G are fixed and assumed to be independent of the level of GDP. Congress decides on a particular level of spending, but it does not determine the magnitude of tax revenues. Instead, it establishes tax rates, and the tax revenues then vary directly with the level of GDP that the economy achieves. Line T represents that direct relationship between tax revenues and GDP. FIGURE 13.3 Built-in stability. Tax revenues, T, vary directly with GDP, and government spending, G, is assumed to be independent of GDP. As GDP falls in a recession, deficits occur automatically and help alleviate the recession. As GDP rises during expansion, surpluses occur automatically and help offset possible inflation. Economic Importance The economic importance of the direct relationship between tax receipts and GDP becomes apparent when we consider that: Taxes reduce spending and aggregate demand. Reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping. As shown in Figure 13.3, tax revenues automatically increase as GDP rises during prosperity, and since taxes reduce household and business spending, they restrain the economic expansion. That is, as the economy moves toward a higher GDP, tax revenues automatically rise and move the budget from deficit toward surplus. In Figure 13.3, observe that the high and perhaps inflationary income level GDP3 automatically generates a contractionary budget surplus. Conversely, as GDP falls during recession, tax revenues automatically decline, increasing spending by households and businesses and thus cushioning the economic contraction. With a falling GDP, tax receipts decline and move the government's budget from surplus toward deficit. In Figure 13.3, the low level of income GDP1 will automatically yield an expansionary budget deficit. Tax Progressivity Figure 13.3 reveals that the size of the automatic budget deficits or surplusesand therefore built-in stabilitydepends on the responsiveness of tax revenues to changes in GDP. If tax revenues change sharply as GDP changes, the slope of line T in the figure will be steep and the vertical distances between T and G (the deficits or surpluses) will be large. If tax revenues change very little when GDP changes, the slope will be gentle and built-in stability will be low. The steepness of T in Figure 13.3 depends on the tax system itself. In a progressive tax systemA tax whose average tax rate increases as the taxpayer's income increases and decreases as the taxpayer's income decreases., the average tax rate (= tax revenue/GDP) rises with GDP. In a proportional tax systemA tax whose average tax rate remains constant as the taxpayer's income increases or decreases., the average tax rate remains constant as GDP rises. In a regressive tax systemA tax whose average tax rate decreases as the taxpayer's income increases and increases as the taxpayer's income decreases., the average tax rate falls as GDP rises. The progressive tax system has the steepest tax line T of the three. However, tax revenues will rise with GDP under both the progressive and the proportional tax systems, and they may rise, fall, or stay the same under a regressive tax system. The main point is this: The more progressive the tax system, the greater the economy's built-in stability. The built-in stability provided by the U.S. tax system has reduced the severity of business fluctuations, perhaps by as much as 8 to 10 percent of the change in GDP that otherwise would have occurred.1 In recession-year 2009, for example, revenues from the individual income tax fell by a staggering 22 percent. This decline helped keep household spending and real GDP from falling even more than they did. But built-in stabilizers can only dampen, not counteract, swings in real GDP. Discretionary fiscal policy (changes in tax rates and expenditures) or monetary policy (central bankcaused changes in interest rates) therefore may be needed to try to counter a recession or inflation of any appreciable magnitude. p. 263 1 Alan J. Auerbach and Daniel Feenberg, The Significance of Federal Taxes as Automatic Stabilizers, Journal of Economic Perspectives, Summer 2000, p. 54. Evaluating Fiscal Policy How can we determine whether a government's discretionary fiscal policy is expansionary, neutral, or contractionary? We cannot simply examine the actual budget deficits or surpluses that take place under the current policy because they will necessarily include the automatic changes in tax revenues that accompany every change in GDP. In addition, the expansionary or contractionary strength of any change in discretionary fiscal policy depends not on its absolute size but on how large it is relative to the size of the economy. So, in evaluating the status of fiscal policy, we must adjust deficits and surpluses to eliminate automatic changes in tax revenues and also compare the sizes of the adjusted budget deficits and surpluses to the level of potential GDP. Cyclically Adjusted Budget Economists use the cyclically adjusted budgetA comparison of the government expenditures and tax collections that would occur if the economy operated at full employment throughout the year; the full-employment budget. (also called the full-employment budget) to adjust actual Federal budget deficits and surpluses to account for the changes in tax revenues that happen automatically whenever GDP changes. The cyclically adjusted budget measures what the Federal budget deficit or surplus would have been under existing tax rates and government spending levels if the economy had achieved its full-employment level of GDP (its potential output). The idea essentially is to compare actual government expenditures with the tax revenues that would have occurred if the economy had achieved fullemployment GDP. That procedure removes budget deficits or surpluses that arise simply because of cyclical changes in GDP and thus tell us nothing about whether the government's current discretionary fiscal policy is fundamentally expansionary, contractionary, or neutral. Consider Figure 13.4a, where line G represents government expenditures and line T represents tax revenues. In full-employment year 1, government expenditures of $500 billion equal tax revenues of $500 billion, as indicated by the intersection of lines G and T at point a. The cyclically adjusted budget deficit in year 1 is zerogovernment expenditures equal the tax revenues forthcoming at the full-employment output GDP1. Obviously, the cyclically adjusted deficit as a percentage of potential GDP is also zero. The government's fiscal policy is neutral. p. 264 FIGURE 13.4 Cyclically adjusted deficits. (a) In the left-hand graph, the cyclically adjusted deficit is zero at the full-employment output GDP1. But it is also zero at the recessionary output GDP2 because the $500 billion of government expenditures at GDP2 equals the $500 billion of tax revenues that would be forthcoming at the full-employment GDP1. There has been no change in fiscal policy. (b) In the right-hand graph, discretionary fiscal policy, as reflected in the downward shift of the tax line from T1 to T2, has increased the cyclically adjusted budget deficit from zero in year 3 (before the tax cut) to $25 billion in year 4 (after the tax cut). This is found by comparing the $500 billion of government spending in year 4 with the $475 billion of taxes that would accrue at the full-employment GDP3. Such a rise in the cyclically adjusted deficit (as a percentage of potential GDP) identifies an expansionary fiscal policy. Now suppose that a recession occurs and GDP falls from GDP 1 to GDP2, as shown in Figure 13.4a. Let's also assume that the government takes no discretionary action, so lines G and T remain as shown in the figure. Tax revenues automatically fall to $450 billion (point c) at GDP2, while government spending remains unaltered at $500 billion (point b). A $50 billion budget deficit (represented by distance bc) arises. But this cyclical deficitA Federal budget deficit that is caused by a recession and the consequent decline in tax revenues. is simply a by-product of the economy's slide into recession, not the result of discretionary fiscal actions by the government. We would be wrong to conclude from this deficit that the government is engaging in an expansionary fiscal policy. The government's fiscal policy has not changed. It is still neutral. That fact is highlighted when we remove the cyclical part of the deficit and thus consider the cyclically adjusted budget deficit for year 2 in Figure 13.4a. The $500 billion of government expenditures in year 2 is shown by b on line G. And, as shown by a on line T, $500 billion of tax revenues would have occurred if the economy had achieved its full-employment GDP. Because both b and a represent $500 billion, the cyclically adjusted budget deficit in year 2 is zero, as is this deficit as a percentage of potential GDP. Since the cyclically adjusted deficits are zero in both years, we know that government did not change its discretionary fiscal policy, even though a recession occurred and an actual deficit of $50 billion resulted. Next, consider Figure 13.4b. Suppose that real output declined from fullemployment GDP3 in year 3 to GDP4 in year 4. Also suppose that government responded to the recession by reducing tax rates in year 4, as represented by the downward shift of the tax line from T1 to T2. What has happened to the size of the cyclically adjusted deficit? Government expenditures in year 4 are $500 billion, as shown by e. Compare that amount with the $475 billion of tax revenues that would occur if the economy achieved its full-employment GDP. That is, compare position e on line G with position h on line T2. The $25 billion of tax revenues by which e exceeds h is the cyclically adjusted budget deficit for year 4. As a percentage of potential GDP, the cyclically adjusted budget deficit has increased from zero in year 3 (before the tax-rate cut) to some positive percent [= ($25 billion/GDP3) 100] in year 4. This increase in the relative size of the full-employment deficit between the two years reveals that the new fiscal policy is expansionary. In contrast, if we observed a cyclically adjusted deficit (as a percentage of potential GDP) of zero in one year, followed by a cyclically adjusted budget surplus in the next, we could conclude that fiscal policy has changed from being neutral to being contractionary. Because the cyclically adjusted budget adjusts for automatic changes in tax revenues, the increase in the cyclically adjusted budget surplus reveals that government either decreased its spending (G) or increased tax rates such that tax revenues (T) increased. These changes in G and T are precisely the discretionary actions that we have identified as elements of a contractionary fiscal policy. Recent U.S. Fiscal Policy Table 13.1 lists the actual Federal budget deficits and surpluses (column 2) and the cyclically adjusted deficits and surpluses (column 3), as percentages of actual GDP and potential GDP, respectively, between 2000 and 2009. Observe that the cyclically adjusted deficits are generally smaller than the actual deficits. This is because the actual deficits include cyclical deficits, whereas the cyclically adjusted deficits eliminate them. Only cyclically adjusted surpluses and deficits as percentages of potential GDP (column 3) provide the information needed to assess discretionary fiscal policy and determine whether it is expansionary, contractionary, or neutral. TABLE 13.1 * Federal Deficits () and Surpluses (+) as Percentages of GDP, 2000 2009 As a percentage of potential GDP. Source: Congressional Budget Office, www.cbo.gov. p. 265 Fiscal Policy from 2000 to 2007 Take a look at the data for 2000, for example, which shows that fiscal policy was contractionary that year. Note that the actual budget surplus was 2.4 percent of GDP in 2000 and the cyclically adjusted budget surplus was 1.1 percent of potential GDP. Because the economy was fully employed and corporate profits were strong, tax revenues poured into the Federal government and exceeded government expenditures. But not all was well in 2000. Specifically, the so-called dot-com stock market bubble burst that year, and the U.S. economy noticeably slowed over the latter half of the year. In March 2001 the economy slid into a recession. Congress and the Bush administration responded by cutting taxes by $44 billion in 2001 and scheduling an additional $52 billion of cuts for 2002. These stimulus policies helped boost the economy and offset the recession as well as cushion the economic blow delivered by the September 11, 2001, terrorist attacks. In March 2002 Congress passed further tax cuts totaling $122 billion over two years and extended unemployment benefits. As Table 13.1 reveals, the cyclically adjusted budget moved from a surplus of 1.1 percent of potential GDP in 2000 to a deficit of 1.3 percent two years later in 2002. Fiscal policy had definitely turned expansionary. Nevertheless, the economy remained sluggish through 2002 and into 2003. In June 2003 Congress again cut taxes, this time by a much larger $350 billion over several years. Specifically, the tax legislation accelerated the reduction of marginal tax rates already scheduled for future years and slashed tax rates on income from dividends and capital gains. It also increased tax breaks for families and small businesses. Note from the table that this tax package increased the cyclically adjusted budget deficit as a percentage of potential GDP to 2.7 percent in 2003. The economy strengthened and both real output and employment grew between 2003 and 2007. By 2007 full employment had been restored, although a 1.2 percent cyclically adjusted budget deficit still remained. Fiscal Policy during the Great Recession As pointed out in previous chapters, major economic trouble began in 2007. In the summer of 2007, a crisis in the market for mortgage loans flared up. Later in 2007 that crisis spread rapidly to other financial markets, threatened the survival of several major U.S. financial institutions, and severely disrupted the entire financial system. As credit markets began to freeze, general pessimism spread beyond the financial markets to the overall economy. Businesses and households retrenched on their borrowing and spending, and in December 2007 the economy entered a recession. Over the following two years, it became known as the Great Recessionone of the steepest and longest economic downturns since the 1930s. In 2008 Congress acted rapidly to pass an economic stimulus package. This law provided a total of $152 billion in stimulus, with some of it coming as tax breaks for businesses, but most of it delivered as checks of up to $600 each to taxpayers, veterans, and Social Security recipients. As a percentage of GDP, the actual Federal budget deficit jumped from 1.2 percent in 2007 to 3.2 percent in 2008. This increase resulted from an automatic drop-off of tax revenues during the recession, along with the tax rebates (fiscal stimulus checks) paid out in 2008. As shown in Table 13.1, the cyclically adjusted budget deficit rose from 1.2 percent of potential GDP in 2007 to 2.8 percent in 2008. This increase in the cyclically adjusted budget reveals that fiscal policy in 2008 was expansionary. The government hoped that those receiving checks would spend the money and thus boost consumption and aggregate demand. But households instead saved substantial parts of the money from the checks or used some of the money to pay down credit card loans. Although this stimulus plan boosted output somewhat in mid-2008, it was neither as expansionary nor long-lasting as policymakers had hoped. The continuing forces of the Great Recession simply overwhelmed the policy. With the economy continuing its precipitous slide, the Obama administration and Congress enacted the American Recovery and Reinvestment Act of 2009. This gigantic $787 billion programcoming on top of a $700 billion rescue package for financial institutionsconsisted of low- and middle-income tax rebates, plus large increases in expenditures on infrastructure, education, and health care. The idea was to flood the economy with additional spending to try to boost aggregate demand and get people back to work. The tax cuts in the package were aimed at lower- and middle-income individuals and households, who were thought to be more likely than highincome people to spend (rather than save) the extra income from the tax rebates. Rather than sending out lump-sum stimulus checks as in 2008, the new tax rebates showed up as small increases in workers' monthly payroll checks. With smaller amounts per month rather than a single large check, the government hoped that people would spend the bulk of their enhanced incomerather than save it as they had done with the one-time-only, lumpsum checks received in 2008. The second part of the fiscal policy (60 percent of the funding) consisted of increases in government expenditures on a wide assortment of programs, including transportation, education, and aid to state governments. The highly stimulative fiscal policy for 2009 is fully reflected in column 3 of Table 13.1. The cyclically adjusted budget deficit rose dramatically from 2.8 percent of potential GDP in 2008 to a very high 7.3 percent of potential GDP in 2009. p. 266 Other nations also experienced recessions and also responded with expansionary fiscal policies. Global Perspective 13.1 shows the magnitudes of the cyclically adjusted surpluses and deficits of a number of countries in 2009. Budget Deficits and Projections Figure 13.5 shows the absolute magnitudes of actual (not cyclically adjusted) U.S. budget surpluses and deficits, here from 1994 through 2009. It also shows the projected future deficits through 2014, as estimated by the Congressional Budget Office (CBO). In recession year 2009, the Federal budget deficit reached $1413 billion, mainly but not totally due to reduced tax revenues from lower income and record amounts of stimulus spending. The CBO projects high deficits for several years to come. But projected deficits and surpluses are subject to large and frequent changes, as government alters its fiscal policy and GDP growth accelerates or slows. So we suggest that you update this figure by going to the Congressional Budget Office Web site, www.cbo.gov, and selecting Budget and Economic Outlook and then Executive Summary. The relevant numbers are in Table 1 in the row labeled Total Deficit. FIGURE 13.5 Federal budget deficits and surpluses, actual and projected, fiscal years 19942014 (in billions of nominal dollars). The annual budget deficits of 1992 through 1997 gave way to budget surpluses from 1998 through 2001. Deficits reappeared in 2002 and declined through 2007. They greatly ballooned in recessionary years 2008 and 2009 and are projected to remain high for many years to come. Source: Congressional Budget Office, www.cbo.gov. GLOBAL PERSPECTIVE 13.1 Cyclically Adjusted Budget Deficits or Surpluses as a Percentage of Potential GDP, Selected Nations Because of the global recession, in 2009 all but a few of the world's major nations had cyclically adjusted budget deficits. These deficits varied as percentages of potential GDP, but they each reflected some degree of expansionary fiscal policy. Source: Organization for Economic Cooperation and Development, OECD Economic Outlook, www.oecd.org. Problems, Criticisms, and Complications p. 267 Economists recognize that governments may encounter a number of significant problems in enacting and applying fiscal policy. Problems of Timing Several problems of timing may arise in connection with fiscal policy: Recognition lag The recognition lag is the time between the beginning of recession or inflation and the certain awareness that it is actually happening. This lag arises because the economy does not move smoothly through the business cycle. Even during good times, the economy has slow months interspersed with months of rapid growth and expansion. This makes recognizing a recession difficult since several slow months will have to happen in succession before people can conclude with any confidence that the good times are over and a recession has begun. The same is true with inflation. Even periods of moderate inflation have months of high inflation so that several high-inflation months must come in sequence before people can confidently conclude that inflation has moved to a higher level. Attempts to reduce the length of the recognition lag by trying to predict the future course of the economy also have proven to be highly difficult, at best. As a result, the economy is often 4 to 6 months into a recession or inflation before the situation is clearly discernible in the relevant statistics. Due to this recognition lag, the economic downslide or the inflation may become more serious than it would have if the situation had been identified and acted on sooner. Administrative lag The wheels of democratic government turn slowly. There will typically be a significant lag between the time the need for fiscal action is recognized and the time action is taken. Following the terrorist attacks of September 11, 2001, the U.S. Congress was stalemated for 5 months before passing a compromise economic stimulus law in March 2002. (In contrast, the Federal Reserve began lowering interest rates the week after the attacks.) Operational lag A lag also occurs between the time fiscal action is taken and the time that action affects output, employment, or the price level. Although changes in tax rates can be put into effect relatively quickly once new laws are passed, government spending on public worksnew dams, interstate highways, and so onrequires long planning periods and even longer periods of construction. Such spending is of questionable use in offsetting short (for example, 6- to 12-month) periods of recession. Consequently, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool. Political Considerations Fiscal policy is conducted in a political arena. That reality not only may slow the enactment of fiscal policy but also may create the potential for political considerations swamping economic considerations in its formulation. It is a human trait to rationalize actions and policies that are in one's self-interest. Politicians are very humanthey want to get reelected. A strong economy at election time will certainly help them. So they may favor large tax cuts under the guise of expansionary fiscal policy even though that policy is economically inappropriate. Similarly, they may rationalize increased government spending on popular items such as farm subsidies, health care, highways, education, and homeland security. At the extreme, elected officials and political parties might collectively hijack fiscal policy for political purposes, cause inappropriate changes in aggregate demand, and thereby cause (rather than avert) economic fluctuations. For instance, before an election, they may try to stimulate the economy to improve their reelection hopes. And then after the election, they may try to use contractionary fiscal policy to dampen the excessive aggregate demand that they caused with their preelection stimulus. In short, elected officials may cause so-called political business cyclesFluctuations in the economy caused by the alleged tendency of Congress to destabilize the economy by reducing taxes and increasing government expenditures before elections and to raise taxes and lower expenditures after elections.swings in overall economic activity and real GDP resulting from election-motivated fiscal policy, rather than from inherent instability in the private sector. Political business cycles are difficult to document and prove, but there is little doubt that political considerations weigh heavily in the formulation of fiscal policy. The question is how often those political considerations run counter to sound economics. Future Policy Reversals Fiscal policy may fail to achieve its intended objectives if households expect future reversals of policy. Consider a tax cut, for example. If taxpayers believe the tax reduction is temporary, they may save a large portion of their tax cut, reasoning that rates will return to their previous level in the future. They save more now so that they will be able draw on this extra savings to maintain their future consumption levels if taxes do indeed rise again in the future. So a tax reduction thought to be temporary may not increase present consumption spending and aggregate demand by as much as our simple model ( Figure 13.1) suggests. p. 268 The opposite may be true for a tax increase. If taxpayers think it is temporary, they may reduce their saving to pay the tax while maintaining their present consumption. They may reason they can restore their saving when the tax rate again falls. So the tax increase may not reduce current consumption and aggregate demand by as much as policymakers intended. To the extent that this so-called consumption smoothing occurs over time, fiscal policy will lose some of its strength. The lesson is that tax-rate changes that households view as permanent are more likely to alter consumption and aggregate demand than tax changes they view as temporary. Offsetting State and Local Finance The fiscal policies of state and local governments are frequently pro-cyclical, meaning that they worsen rather than correct recession or inflation. Unlike the Federal government, most state and local governments face constitutional or other legal requirements to balance their budgets. Like households and private businesses, state and local governments increase their expenditures during prosperity and cut them during recession. During the Great Depression of the 1930s, most of the increase in Federal spending was offset by decreases in state and local spending. During and immediately following the recession of 2001, many state and local governments had to offset lower tax revenues resulting from the reduced personal income and spending of their citizens. They offset the decline by in revenues raising tax rates, imposing new taxes, and reducing spending. In view of these past experiences, the $787 billion fiscal package of 2009 made a special effort to reduce this problem by giving substantial aid dollars to state governments. Because of the sizable Federal aid, the states did not have to increase taxes and reduce expenditure by as much as otherwise. So their collective fiscal actions did not fight as much against the increase in aggregate demand that the Federal government wanted to achieve with its tax cuts and expenditure increases. Crowding-Out Effect Another potential flaw of fiscal policy is the so-called crowding-out effect A rise in interest rates and a resulting decrease in planned investment caused by the Federal government's increased borrowing to finance budget deficits and refinance debt.: An expansionary fiscal policy (deficit spending) may increase the interest rate and reduce investment spending, thereby weakening or canceling the stimulus of the expansionary policy. The rising interest rate might also potentially crowd out interest-sensitive consumption spending (such as purchasing automobiles on credit). But since investment is the most volatile component of GDP, the crowding-out effect focuses its attention on investment and whether the stimulus provided by deficit spending may be partly or even fully neutralized by an offsetting reduction in investment spending. ORIGIN OF THE IDEA O 13.2 Crowding out To see the potential problem, realize that whenever the government borrows money (as it must if it is deficit spending), it increases the overall demand for money. If the monetary authorities are holding the money supply constant, this increase in demand will raise the price paid for borrowing money: the interest rate. Because investment spending varies inversely with the interest rate, some investment will be choked off or crowded out. Economists vary in their opinions about the strength of the crowding-out effect. An important thing to keep in mind is that crowding out is likely to be less of a problem when the economy is in recession, because investment demand tends to be weak. Why? Because output purchases slow during recessions and therefore most businesses end up with substantial excess capacity. As a result, they do not have much incentive to add new machinery or build new factories. After all, why should they add capacity when some of the capacity they already have is lying idle? With investment demand weak during a recession, the crowding-out effect is likely to be very small. Simply put, there is not much investment for the government to crowd out. Even if deficit spending does increase the interest rate, the effect on investment may be fully offset by the improved investment prospects that businesses expect from the fiscal stimulus. By contrast, when the economy is operating at or near full capacity, investment demand is likely to be quite strong so that crowding out will probably be a much more serious problem. When the economy is booming, factories will be running at or near full capacity and firms will have high investment demand for two reasons. First, equipment running at full capacity wears out fast, so firms will be investing substantial amounts just to replace machinery and equipment that wears out and depreciates. Second, the economy is likely to be growing overall so that firms will be heavily investing to add to their production capacity to take advantage of the greater anticipated demand for their outputs. p. 269 Current Thinking on Fiscal Policy Where do these complications leave us as to the advisability and effectiveness of discretionary fiscal policy? In view of the complications and uncertain outcomes of fiscal policy, some economists argue that it is better not to engage in it at all. Those holding that view point to the superiority of monetary policy (changes in interest rates engineered by the Federal Reserve) as a stabilizing device or believe that most economic fluctuations tend to be mild and self-correcting. But most economists believe that fiscal policy remains an important, useful policy lever in the government's macroeconomic toolkit. The current popular view is that fiscal policy can help push the economy in a particular direction but cannot fine-tune it to a precise macroeconomic outcome. Mainstream economists generally agree that monetary policy is the best month-to-month stabilization tool for the U.S. economy. If monetary policy is doing its job, the government should maintain a relatively neutral fiscal policy, with a cyclically adjusted budget deficit or surplus of no more than 2 percent of potential GDP. It should hold major discretionary fiscal policy in reserve to help counter situations where recession threatens to be deep and long lasting, as in 2008 and 2009, or where a substantial reduction in aggregate demand might help the Federal Reserve to quell a major bout of inflation. Finally, economists agree that proposed fiscal policy should be evaluated for its potential positive and negative impacts on long-run productivity growth. The short-run policy tools used for conducting active fiscal policy often have long-run impacts. Countercyclical fiscal policy should be shaped to strengthen, or at least not impede, the growth of long-run aggregate supply (shown as a rightward shift of the long-run aggregate supply curve in Figure 12.5). For example, a tax cut might be structured to enhance work effort, strengthen investment, and encourage innovation. Alternatively, an increase in government spending might center on preplanned projects for public capital (highways, mass transit, ports, airports), which are complementary to private investment and thus support long-term economic growth. QUICK REVIEW 13.2 Automatic changes in net taxes (taxes minus transfers) add a degree of built-in stability to the economy. Cyclical deficits arise from declines in net tax revenues that automatically occur as the economy recedes and incomes and profits fall. The cyclically adjusted budget eliminates cyclical effects on net tax revenues; it compares actual levels of government spending to the projected levels of net taxes that would occur if the economy were achieving its full-employment output. Time lags, political problems, expectations, and state and local finances complicate fiscal policy. The crowding-out effect indicates that an expansionary fiscal policy may increase the interest rate and reduce investment spending. The U.S. Public Debt The U.S. national debt, or public debtThe total amount owed by the Federal government to the owners of government securities; equal to the sum of past government budget deficits less government budget surpluses. , is essentially the accumulation of all past Federal deficits and surpluses. The deficits have greatly exceeded the surpluses and have emerged mainly from war financing, recessions, and fiscal policy. In 2009 the total public debt was $11.9 trillion $6.8 trillion held by the public, excluding the Federal Reserve; and $5.1 trillion held by Federal agencies and the Federal Reserve. Between 2007 and 2009, the public debt expanded by a huge $2.9 trillion. During the Great Recession, Federal tax revenues plummeted because incomes and profit fell, and Federal expenditures jumped because of huge spending to rescue failing financial institutions and to stimulate the shrinking economy. You can find the current size of the public debt at the Web site of the Department of Treasury, Bureau of the Public Debt, at www.treasurydirect.gov/NP/BPDLogin?application=np . At this site, you will see that the U.S. Treasury defines the public to include the Federal Reserve. But because the Federal Reserve is the nation's central bank, economists view it as essentially part of the Federal government and not part of the public. Economists typically focus on the part of the debt that is not owned by the Federal government and the Federal Reserve. Ownership The total public debt of $11.9 trillion represents the total amount of money owed by the Federal government to the holders of U.S. securities U.S. Treasury bills, notes, and bonds used to finance budget deficits; the components of the public debt.: financial instruments issued by the Federal government to borrow money to finance expenditures that exceed tax revenues. These U.S. securities (loan instruments) are of four types: Treasury bills (short-term securities), Treasury notes (medium-term securities), Treasury bonds (long-term securities), and U.S. savings bonds (long-term, nonmarketable bonds). p. 270 Figure 13.6 shows that the public, sans the Federal Reserve, held 57 percent of the Federal debt in 2009 and that Federal government agencies and the Federal Reserve held the remaining 43 percent. The Federal agencies hold U.S. securities as risk-free assets that they can cash in as needed to make latter payments. The Federal Reserve holds these securities to facilitate the open-market operations that it uses to control the nation's money supply (Chapter 16). Observe that the public in the pie chart consists of individuals here and abroad, state and local governments, and U.S. financial institutions. Foreigners held about 29 percent of the total U.S. public debt in 2009, meaning that most of the U.S. public debt is held internally and not externally. Americans owed 71 percent of the public debt to Americans. Of the $3.7 trillion of debt held by foreigners, China held 24 percent, Japan held 21 percent, and oil-exporting nations held 6 percent. FIGURE 13.6 Ownership of the total public debt, 2009. The $11.9 trillion public debt can be divided into the proportion held by the public, excluding the Federal Reserve (57 percent), and the proportion held by Federal agencies and the Federal Reserve System (43 percent). Of the total debt, 29 percent is foreign-owned. Source: Economic Report of the President, 2010, www.gpoaccess.gov/eop; authors' derivation from Table B-89, September 2009 data. Federal Reserve percentage is from the U.S. Treasury, www.fms.treas.gov/bulletin. Debt and GDP A simple statement of the absolute size of the debt ignores the fact that the wealth and productive ability of the U.S. economy is also vast. A wealthy, highly productive nation can incur and carry a large public debt much more easily than a poor nation can. A more meaningful measure of the public debt relates it to an economy's GDP. Figure 13.7 shows the yearly relative sizes of the U.S. public debt held outside the Federal Reserve and Federal agencies. In 2009 the percentage was 47 percent. Most noticeably, the percentage rose dramatically in 2008 and 2009 because of huge budget deficits together with declining real GDP. FIGURE 13.7 Federal debt held by the public, excluding the Federal Reserve, as a percentage of GDP, 19702009. As a percentage of GDP, the Federal debt held by the public (held outside the Federal Reserve and Federal government agencies) increased sharply over the 19801995 period and declined significantly between 1995 and 2001. Since 2001, the percentage has gone up again, and jumped abruptly and sharply in 2008 and 2009. Source: Derived by the authors by subtracting Fed-held debt ( www.fms.treas.gov/bulletin) from debt held by the public (www.gpoaccess.gov/eop). International Comparisons It is not uncommon for countries to have sizable public debts. As shown in Global Perspective 13.2, the public debt as a percentage of real GDP in the United States is neither particularly high nor low relative to such debt percentages in other advanced industrial nations. Interest Charges Many economists conclude that the primary burden of the debt is the annual interest charge accruing on the bonds sold to finance the debt. In 2009 interest on the total public debt was $187 billion. Although this amount is sizable in absolute terms, it was only 1.3 percent of GDP for 2009. So, the Federal government had to collect taxes equal to 1.3 percent of GDP to service the total public debt. This percentage was down from 3.2 percent in 1990 and 2.3 percent in 2000, mainly because interest rates in 2009 were extremely low. p. 271 GLOBAL PERSPECTIVE 13.2 Publicly Held Debt: International Comparisons Although the United States has the world's largest public debt, a number of other nations have larger debts as percentages of their GDPs. Source: Organization for Economic Cooperation and Development, OECD Economic Outlook, www.oecd.org. These debt calculations encompass Federal, state, and local debt, including the debt of government-owned enterprises (not just Federal debt as in Figure 13.7). False Concerns You may wonder if the large public debt might bankrupt the United States or at least place a tremendous burden on your children and grandchildren. Fortunately, these are largely false concerns. People were wondering the same things 50 years ago! Bankruptcy The large U.S. public debt does not threaten to bankrupt the Federal government, leaving it unable to meet its financial obligations. There are two main reasons: refinancing and taxation. Refinancing As long as the U.S. public debt is viewed by lenders as manageable and sustainable, the public debt is easily refinanced. As portions of the debt come due on maturing Treasury bills, notes, and bonds each month, the government does not cut expenditures or raise taxes to provide the funds required. Rather, it refinances the debt by selling new bonds and using the proceeds to pay holders of the maturing bonds. The new bonds are in strong demand because lenders can obtain a market-determined interest return with no risk of default by the Federal government. Of course, refinancing could become an issue with a high enough debt-toGDP ratio. Some countries such as Greece have run into this problem. High and rising ratios in the United States might raise fears that the U.S. government might be unable to pay back loans as they come due. But, with the present U.S. debt-to-GDP ratio and the prospects of long-term economic growth, this is a false concern for the United States. Taxation The Federal government has the constitutional authority to levy and collect taxes. A tax increase is a government option for gaining sufficient revenue to pay interest and principal on the public debt. Financially distressed private households and corporations cannot extract themselves from their financial difficulties by taxing the public. If their incomes or sales revenues fall short of their expenses, they can indeed go bankrupt. But the Federal government does have the option to impose new taxes or increase existing tax rates if necessary to finance its debt. Such tax hikes may be politically unpopular and may weaken incentives to work and invest, but they are a means of raising funds to finance the debt. Burdening Future Generations In 2009 public debt per capita was $37,437. Was each child born in 2009 handed a $37,437 bill from the Federal government? Not really. The public debt does not impose as much of a burden on future generations as commonly thought. The United States owes a substantial portion of the public debt to itself. U.S. citizens and institutions (banks, businesses, insurance companies, governmental agencies, and trust funds) own about 71 percent of the U.S. government securities. Although that part of the public debt is a liability to Americans (as taxpayers), it is simultaneously an asset to Americans (as holders of Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds). To eliminate the American-owned part of the public debt would require a gigantic transfer payment from Americans to Americans. Taxpayers would pay higher taxes, and holders of the debt would receive an equal amount for their U.S. securities. Purchasing power in the United States would not change. Only the repayment of the 29 percent of the public debt owned by foreigners would negatively impact U.S. purchasing power. p. 272 The public debt increased sharply during the Second World War. But the decision to finance military purchases through the sale of government bonds did not shift the economic burden of the war to future generations. The economic cost of the Second World War consisted of the civilian goods society had to forgo in shifting scarce resources to war goods production (recall production possibilities analysis). Regardless of whether society financed this reallocation through higher taxes or through borrowing, the real economic burden of the war would have been the same. That burden was borne almost entirely by those who lived during the war. They were the ones who did without a multitude of consumer goods to enable the United States to arm itself and its allies. The next generation inherited the debt from the war but also an equal amount of government bonds that would pay them cash in future years. It also inherited the enormous benefits from the victorynamely, preserved political and economic systems at home and the export of those systems to Germany, Italy, and Japan. Those outcomes enhanced postwar U.S. economic growth and helped raise the standard of living of future generations of Americans. Substantive Issues Although the preceding issues relating to the public debt are false concerns, a number of substantive issues are not. Economists, however, attach varying degrees of importance to them. Income Distribution The distribution of ownership of government securities is highly uneven. Some people own much more than the $37,437-per-person portion of government securities; other people own less or none at all. In general, the ownership of the public debt is concentrated among wealthier groups, who own a large percentage of all stocks and bonds. Because the overall Federal tax system is only slightly progressive, payment of interest on the public debt mildly increases income inequality. Income is transferred from people who, on average, have lower incomes to the higher-income bondholders. If greater income equality is one of society's goals, then this redistribution is undesirable. Incentives The current public debt necessitates annual interest payments of $187 billion. With no increase in the size of the debt, that interest charge must be paid out of tax revenues. Higher taxes may dampen incentives to bear risk, to innovate, to invest, and to work. So, in this indirect way, a large public debt may impair economic growth and therefore impose a burden of reduced output (and income) on future generations. Foreign-Owned Public Debt The 29 percent of the U.S. debt held by citizens and institutions of foreign countries is an economic burden to Americans. Because we do not owe that portion of the debt to ourselves, the payment of interest and principal on this external public debtThe portion of the public debt owed to foreign citizens, firms, and institutions. enables foreigners to buy some of our output. In return for the benefits derived from the borrowed funds, the United States transfers goods and services to foreign lenders. Of course, Americans also own debt issued by foreign governments, so payment of principal and interest by those governments transfers some of their goods and services to Americans. Crowding-Out Effect Revisited A potentially more serious problem is the financing (and continual refinancing) of the large public debt, which can transfer a real economic burden to future generations by passing on to them a smaller stock of capital goods. This possibility involves the previously discussed crowding-out effect : the idea that public borrowing drives up real interest rates, which reduces private investment spending. If public borrowing only happened during recessions, crowding out would not likely be much of a problem. Because private investment demand tends to be weak during recessions, any increase in interest rates caused by public borrowing will at most cause a small reduction in investment spending. In contrast, the need to continuously finance a large public debt may be more troublesome. At times, that financing requires borrowing large amounts of money when the economy is near or at its full-employment output. Because this usually is when private demand is strong, any increase in interest rates caused by the borrowing necessary to refinance the debt may result in a substantial decline in investment spending. If the amount of current investment crowded out is extensive, future generations will inherit an economy with a smaller production capacity and, other things equal, a lower standard of living. p. 273 A Graphical Look at Crowding Out We know from Chapter 10 that the amount of investment spending is inversely related to the real interest rate. When graphed, that relationship is shown as a downsloping investment demand curve, such as either ID1 or ID2 in Figure 13.8. Let's first consider curve ID1. (Ignore curve ID2 for now.) Suppose that government borrowing increases the real interest rate from 6 percent to 10 percent. Investment spending will then fall from $25 billion to $15 billion, as shown by the economy's move from a to b. That is, the financing of the debt will compete with the financing of private investment projects and crowd out $10 billion of private investment. So the stock of private capital handed down to future generations will be $10 billion less than it would have been without the need to finance the public debt. FIGURE 13.8 The investment demand curve and the crowding-out effect. If the investment demand curve (ID1) is fixed, the increase in the interest rate from 6 percent to 10 percent caused by financing a large public debt will move the economy from a to b, crowding out $10 billion of private investment and decreasing the size of the capital stock inherited by future generations. However, if the public goods enabled by the debt improve the investment prospects of businesses, the private investment demand curve will shift rightward, as from ID1 to ID2. That shift may offset the crowding-out effect wholly or in part. In this case, it moves the economy from a to c. Public Investments and Public-Private Complementarities But even with crowding out, two factors could partly or fully offset the net economic burden shifted to future generations. First, just as private expenditures may involve either consumption or investment, so it is with public goods. Part of the government spending enabled by the public debt is for public investment outlays (for example, highways, mass transit systems, and electric power facilities) and human capital (for example, investments in education, job training, and health). Like private expenditures on machinery and equipment, those public investmentsGovernment expenditures on public capital (such as roads, highways, bridges, mass-transit systems, and electric power facilities) and on human capital (such as education, training, and health). increase the economy's future production capacity. Because of the financing through debt, the stock of public capital passed on to future generations may be higher than otherwise. That greater stock of public capital may offset the diminished stock of private capital resulting from the crowding-out effect, leaving overall production capacity unimpaired. So-called public-private complementarities are a second factor that could reduce the crowding out effect. Some public and private investments are complementary. Thus, the public investment financed through debt could spur some private-sector investment by increasing its expected rate of return. For example, a Federal building in a city may encourage private investment in the form of nearby office buildings, shops, and restaurants. Through its complementary effect, the spending on public capital may shift the private investment demand curve to the right, as from ID1 to ID2 in Figure 13.8. Even though the government borrowing boosts the interest rate from 6 percent to 10 percent, total private investment need not fall. In the case shown as the move from a to c in Figure 13.8, it remains at $25 billion. Of course, the increase in investment demand might be smaller than that shown. If it were smaller, the crowding-out effect would not be fully offset. But the point is that an increase in investment demand may counter the decline in investment that would otherwise result from the higher interest rate. QUICK REVIEW 13.3 The U.S. public debt$11.9 trillion in 2009is essentially the total accumulation of all past Federal budget deficits and surpluses; about 29 percent of the U.S. public debt is held by foreigners. The U.S. public debt held by the public (excluding the Federal Reserve) was 47 percent of GDP in 2009, up from 30 percent in 2000. The Federal government is in no danger of going bankrupt because it needs only to refinance (not retire) the public debt and it can raise revenues, if needed, through higher taxes. The borrowing and interest payments associated with the public debt may (a) increase income inequality; (b) require higher taxes, which may dampen incentives; and (c) impede the growth of the nation's stock of capital through crowding out of private investment. p. 274 LAST Word The Social Security and Medicare Shortfalls Social Security and Medicare Face Gigantic Future Funding Shortfalls. Metaphorically Speaking, Some Economists See These Programs as Financial and Political Time Bombs The American population, on average, is getting decidedly older. The percentage of the populati age 62 or older will rise substantially over the next several decades, with the greatest increases people age 75 and above. In the future, more people will be receiving Social Security benefits (in during retirement) and Medicare (medical care during retirement) for longer periods. Each perso benefits will be paid for by fewer workers. The number of workers per Social Security and Medic beneficiary was roughly 5:1 in 1960. Today it is 3:1, and by 2040 it will be only 2:1. The combined cost of the Social Security and Medicare programs was 7.6 percent of GDP in 20 and that percentage is projected to grow to 12 percent of GDP in 2030 and 17.2 percent of GDP 2083.* * Social Security and Medicare Board of Trustees, Status of the Social Security and Medicare Programs: A Summar 2009 Annual Reports, www.ssa.gov. This publication is also the source of most of the statistical information that fo The Social Security Shortfall Social Security is the major public retirement program in the U States. The program costs $615 billion annually and is financed by a 12.4 percent tax on earning to a set level of earnings ($106,800 in 2009). Half the tax (6.2 percent) is paid by the worker; the half by the employer. Social Security is largely an annual pay-as-you-go plan, meaning that mo the current revenues from the Social Security tax are paid to current Social Security retirees. Th the start of 2009, Social Security revenues exceeded Social Security payouts in anticipation of th large benefits promised to the baby boomers when they retire. That excess inflow was used to b U.S. Treasury securities that were credited to a government account called the Social Security T Fund. But the combined accumulation of money in the trust fund through 2009 plus the projected future revenues from the payroll tax in later years was expected to be greatly inadequate for pay the promised retirement benefits to all future retirees. This underfunding of future retirement promises was brought into sharper focus in the latter half 2009 when for the first time, Social Security revenues fell below Social Security retirement payo and the system started shifting money from the trust fund to make up the difference. The trust fu expected to be exhausted in 2037. For each year thereafter, annual tax revenues will cover only percent of the promised benefits. The Medicare Shortfall The Medicare program is the U.S. health care program for people ag and older in the United States. The program costs $462 billion per year and has been growing a about 9 percent annually. Like Social Security, it also is a pay-as-you-go plan, meaning that curr medical benefits for people age 65 or older are being funded by current tax revenues from the 2 percent Medicare tax on earnings. Like the Social Security tax, half the Medicare tax is paid by t employer (1.45 percent) and half the by the employee. But the 2.9 percent Medicare tax is applie all earnings. The financial status of Medicare is much worse than that of Social Security. To begin with, the Medicare Trust Fund will be depleted in 2017, 20 years before the Social Security Trust Fund is expected to be depleted. Then, in subsequent years, the percentage of scheduled Medicare ben covered by the Medicare tax will decline from 81 percent in 2017 to 50 percent in 2035 and 29 p in 2080. p. 275 The Unpleasant Options To restore long-run balance to Social Security and Medicare, the Fe government must either reduce benefits or increase revenues. It's as simpleand as complicate that! The Social Security Administration concludes that bringing projected Social Security revenu and payments into balance over the next 75 years would require a 16 percent permanent reduct Social Security benefits, a 13 percent permanent increase in tax revenues, or some combination the two. To bring projected Medicare revenues and expenses into long-run balance would requir increase in the Medicare payroll tax by 122 percent, a 51 percent reduction of Medicare paymen from their projected levels, or some combination of each. All the general options for closing all or part of the Social Security and Medicare gaps involve dif economic trade-offs and dangerous political risks, because one group or another will strongly op them. Here are just a few examples: Increasing the retirement age for collecting Social Security or Medicare benefits will upse preretirement workers who have been paying into the system and will receive their benefi later than they expected. Subjecting a larger portion of total earnings to the Social Security tax would constitute a gigantic tax increase on the earnings of the country's highest trained and educated individ This might reduce the incentive of younger people to obtain education and advance in the careers. Disqualifying wealthy individuals from receiving Social Security and Medicare benefits wo the programs toward welfare and redistribution, rather than insurance programs. This wou undermine the broad existing political support for the programs. Redirecting legal immigration toward high-skilled, high-earning entrants and away from lo skilled, low-earning immigrants to raise Social Security and Medicare revenues would als raise the ire of some native-born high-skilled workers and the proponents of immigration b on family reunification. Placing the payroll tax revenues into accounts that individuals, not the government, would maintain, and bequeath would transform the Social Security and Medicare programs from guaranteed defined benefit plans into much riskier defined contribution plans. The extr short-run volatility of the stock market might leave some unlucky people destitute in old a The problem is huge and will not go away. One recent attempt to add up the underfunding of all promised Social Security and Medicare benefits finds that the total underfunding greatly exceed combined current wealth (net worth) of everyone in the United States today. Even if this estima somewhat extreme, the fact remains: The Federal government and American people eventually have to face up to the overpromising-underfunding problem and find ways to resolve it. Bruce Bartlett, The 81% Tax Increase, Forbes.com, August 8, 2009, www.forbes.com. Summary 1. Fiscal policy consists of deliberate changes in government spending, taxes, or some combination of both to promote full employment, price-level stability, and economic growt Fiscal policy requires increases in government spending, decreases in taxes, or botha budget deficitto increase aggregate demand and push an economy from a recession. Decreases in government spending, increases in taxes, or botha budget surplusare appropriate fiscal policy for decreasing aggregate demand to try to slow or halt demand-p inflation. 2. Built-in stability arises from net tax revenues, which vary directly with the level of GDP. Du recession, the Federal budget automatically moves toward a stabilizing deficit; during expansion, the budget automatically moves toward an anti-inflationary surplus. Built-in sta lessens, but does not fully correct, undesired changes in real GDP. 3. Actual Federal budget deficits can go up or down because of changes in GDP, changes in fiscal policy, or both. Deficits caused by changes in GDP are called cyclical deficits. The cyclically adjusted budget removes cyclical deficits from the budget and therefore measur budget deficit or surplus that would occur if the economy operated at its full-employment throughout the year. Changes in the cyclical-budget deficit or surplus provide meaningful information as to whether the government's fiscal policy is expansionary, neutral, or contractionary. Changes in the actual budget deficit or surplus do not, since such deficits surpluses can include cyclical deficits or surpluses. p. 276 4. In 2001 the Bush administration and Congress chose to reduce marginal tax rates and ph out the Federal estate tax. A recession occurred in 2001, and Federal spending for the wa terrorism rocketed. The Federal budget swung from a surplus of $128 billion in 2001 to a of $158 billion in 2002. In 2003 the Bush administration and Congress accelerated the tax reductions scheduled under the 2001 tax law and cut tax rates on capital gains and divide The purposes were to stimulate a sluggish economy. By 2007 the economy had reached employment level of output. 5. The Federal government responded to the deep recession of 20072009 by implementin highly expansionary fiscal policy. In 2008 the Federal government passed a tax rebate pr that sent $600 dollar checks to qualified individuals. Later that year, it created a $700 billi emergency fund to keep key financial institutions from failing. These and other programs increased the cyclically adjusted budget deficit from 1.2 percent of potential GDP in 200 2.8 percent in 2008. When the economy continued to plunge, the Obama administration Congress enacted a massive $787 billion stimulus program to be implemented over 2 y The cyclically adjusted budget deficit shot up from 2.8 percent of potential GDP in 2008 7.3 percent in 2009. 6. Certain problems complicate the enactment and implementation of fiscal policy. They incl (a) timing problems associated with recognition, administrative, and operational lags; (b) potential for misuse of fiscal policy for political rather than economic purposes; (c) the fac state and local finances tend to be pro-cyclical; (d) potential ineffectiveness if households expect future policy reversals; and (e) the possibility of fiscal policy crowding out private investment. 7. Most economists believe that fiscal policy can help move the economy in a desired direct but cannot reliably be used to fine-tune the economy to a position of price stability and ful employment. Nevertheless, fiscal policy is a valuable backup tool for aiding monetary pol fighting significant recession or inflation. 8. The public debt is the total accumulation of all past Federal government deficits and surp and consists of Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds. 2009 the U.S. public debt was $11.9 trillion, or $37,437 per person. The public (which her includes banks and state and local governments) holds 57 percent of that Federal debt; th Federal Reserve and Federal agencies hold the other 43 percent. Foreigners hold 29 per of the Federal debt. Interest payments as a percentage of GDP were about 1.3 percent in This is down from 3.2 percent in 1990. 9. The concern that a large public debt may bankrupt the U.S. government is generally a fal worry because (a) the debt needs only to be refinanced rather than refunded and (b) the Federal government has the power to increase taxes to make interest payments on the d 10. In general, the public debt is not a vehicle for shifting economic burdens to future generat Americans inherit not only most of the public debt (a liability) but also most of the U.S. securities (an asset) that finance the debt. 11. More substantive problems associated with public debt include the following: (a) Paymen interest on the debt may increase income inequality. (b) Interest payments on the debt re higher taxes, which may impair incentives. (c) Paying interest or principal on the portion o debt held by foreigners means a transfer of real output abroad. (d) Government borrowing refinance or pay interest on the debt may increase interest rates and crowd out private investment spending, leaving future generations with a smaller stock of capital than they have had otherwise. 12. The increase in investment in public capital that may result from debt financing may partly wholly offset the crowding-out effect of the public debt on private investment. Also, the ad public investment may stimulate private investment, where the two are complements. Terms and Concepts fiscal policyChanges in government spending and tax collections designed to achieve a fullemployment and noninflationary domestic output; also called discretionary fiscal policy. Council of Economic Advisers (CEA)A group of three persons that advises and assists the presi of the United States on economic matters (including the preparation of the annual Economic Re the President). expansionary fiscal policyAn increase in government purchases of goods and services, a decrea net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output. budget deficitThe amount by which the expenditures of the Federal government exceed its reve in any year. contractionary fiscal policyA decrease in government purchases of goods and services, an incre net taxes, or some combination of the two, for the purpose of decreasing aggregate demand an controlling inflation. budget surplusThe amount by which the revenues of the Federal government exceed its expend in any year. built-in stabilizerA mechanism that increases government's budget deficit (or reduces its surplus during a recession and increases government's budget surplus (or reduces its deficit) during an expansion without any action by policymakers. The tax system is one such mechanism. progressive tax systemA tax whose average tax rate increases as the taxpayer's income increas and decreases as the taxpayer's income decreases. proportional tax systemA tax whose average tax rate remains constant as the taxpayer's income increases or decreases. regressive tax systemA tax whose average tax rate decreases as the taxpayer's income increas and increases as the taxpayer's income decreases. cyclically adjusted budgetA comparison of the government expenditures and tax collections that occur if the economy operated at full employment throughout the year; the full-employment budg cyclical deficitA Federal budget deficit that is caused by a recession and the consequent decline revenues. political business cycleFluctuations in the economy caused by the alleged tendency of Congress destabilize the economy by reducing taxes and increasing government expenditures before elec and to raise taxes and lower expenditures after elections. crowding-out effectA rise in interest rates and a resulting decrease in planned investment cause the Federal government's increased borrowing to finance budget deficits and refinance debt. public debtThe total amount owed by the Federal government to the owners of government secu equal to the sum of past government budget deficits less government budget surpluses. U.S. securitiesU.S. Treasury bills, notes, and bonds used to finance budget deficits; the compon of the public debt. external public debtThe portion of the public debt owed to foreign citizens, firms, and institutions public investmentsGovernment expenditures on public capital (such as roads, highways, bridges mass-transit systems, and electric power facilities) and on human capital (such as education, tra and health). Questions p. 277 1. What is the role of the Council of Economic Advisers (CEA) as it relates to fiscal policy? U Internet search to find the names and university affiliations of the present members of the LO1 2. What are government's fiscal policy options for ending severe demand-pull inflation? Whi these fiscal options do you think might be favored by a person who wants to preserve the of government? A person who thinks the public sector is too large? How does the ratche effect affect anti-inflationary fiscal policy? LO1 3. (For students who were assigned Chapter 11) Use the aggregate expenditures model to how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap (Figure 11.7). Explain how equal-size increases in G and T c eliminate a recessionary gap and how equal-size decreases in G and T could eliminate a inflationary gap. LO1 4. Some politicians have suggested that the United States enact a constitutional amendmen requiring that the Federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact a contractionary fisc policy whenever the economy experienced a severe recession. LO1 5. Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the idea of a political business cycle. How might expectations of a near-term polic reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out ef and why might it be relevant to fiscal policy? In view of your answers, explain the followin statement: Although fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the economy to the full-employment, noninflationary level of real GDP and keep the economy indefinitely. LO1 6. Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy's buil stability? LO2 7. Define the cyclically adjusted budget, explain its significance, and state why it may differ f the actual budget. Suppose the full-employment, noninflationary level of real output is GD (not GDP2) in the economy depicted in Figure 13.3. If the economy is operating at GDP2, instead of GDP3, what is the status of its cyclically adjusted budget? The status of its curr fiscal policy? What change in fiscal policy would you recommend? How would you accom that in terms of the G and T lines in the figure? LO3 8. How do economists distinguish between the absolute and relative sizes of the public debt Why is the distinction important? Distinguish between refinancing the debt and retiring the How does an internally held public debt differ from an externally held public debt? Contra effects of retiring an internally held debt and retiring an externally held debt. LO4 9. True or false? If false, explain why. LO4 a. The total public debt is more relevant to an economy than the public debt as a percentage of GDP. b. An internally held public debt is like a debt of the left hand owed to the right hand. c. The Federal Reserve and Federal government agencies hold more than three-four the public debt. d. The portion of the U.S. debt held by the public (and not by government entities) wa larger as a percentage of GDP in 2009 than it was in 2000. e. As a percentage of GDP, the total U.S. public debt is the highest such debt among world's advanced industrial nations. 10. Why might economists be quite concerned if the annual interest payments on the U.S. pu debt sharply increased as a percentage of GDP? LO4 11. Trace the cause-and-effect chain through which financing and refinancing of the public de might affect real interest rates, private investment, the stock of capital, and economic gro How might investment in public capital and complementarities between public capital and private capital alter the outcome of the cause-effect chain? LO4 12. LAST WORD What do economists mean when they say Social Security and Medicare ar pay-as-you-go plans? What are the Social Security and Medicare trust funds, and how l will they have money left in them? What is the key long-run problem of both Social Secur Medicare? Do you favor increasing taxes or do you prefer reducing benefits to fix the prob Problems 1. Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Determine one possible combination of government spending increases and tax decreases that would accomplish the same goal. LO1 2. Refer back to the table in Figure 12.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level. By what percentage will the price level increase? Will this inflation be demandpull inflation or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it? LO1 p. 278 3. (For students who were assigned Chapter 11) Assume that, without taxes, the consumption schedule for an economy is as shown below: LO1 a. Graph this consumption schedule. What is the size of the MPC? b. Assume that a lump-sum (regressive) tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with those of the pretax consumption schedule. c. Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. Calculate and graph the new consumption schedule and note the MPC and the multiplier. d. Finally, impose a progressive tax such that the tax rate is 0 percent when GDP is $100, 5 percent at $200, 10 percent at $300, 15 percent at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC and the multiplier. e. Use a graph similar to Figure 13.3 to show why proportional and progressive taxes contribute to greater economic stability, while a regressive tax does not. 4. Refer to the accompanying table for Waxwania: LO2, LO3 a. What is the marginal tax rate in Waxwania? The average tax rate? Which of the following describes the tax system: proportional, progressive, regressive? b. Suppose Waxwania is producing $600 of real GDP, whereas the potential real GDP (or full-employment real GDP) is $700. How large is its budget deficit? Its cyclically adjusted budget deficit? Its cyclically adjusted budget deficit as a percentage of potential real GDP? Is Waxwania's fiscal policy expansionary or is it contractionary? 5. Suppose that a country has no public debt in year 1 but experiences a budget deficit of $40 billion in year 2, a budget deficit of $20 billion in year 3, a budget surplus of $10 billion in year 3, and a budget deficit of $2 billion in year 4. What is the absolute size of its public debt in year 4? If its real GDP in year 4 is $104 billion, what is this country's public debt as a percentage of real GDP in year 4? LO4 6. Suppose that the investment demand curve in a certain economy is such that investment declines by $100 billion for every 1 percentage point increase in the real interest rate. Also, suppose that the investment demand curve shifts rightward by $150 billion at each real interest rate for every 1 percentage point increase in the expected rate of return from investment. If stimulus spending (an expansionary fiscal policy) by government increases the real interest rate by 2 percentage points, but also raises the expected rate of return on investment by 1 percentage point, how much investment, if any, will be crowded out? LO4 FURTHER TEST YOUR KNOWLEDGE AT www.mcconnell19e.com At the text's Online Learning Center (OLC), www.mcconnell19e.com, you will find one or more Web-based questions that require information from the Internet to answer. We urge you to check them out; they will familiarize you with Web sites that may be helpful in other courses and perhaps even in your career. The OLC also features multiple-choice questions that give instant feedback and provides other helpful ways to further test your knowledge of the chapter.
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