Topic12-Fiscal Policy_AAP_Rev

Topic12-Fiscal Policy_AAP_Rev - The Government and Fiscal...

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Unformatted text preview: The Government and Fiscal Policy Taxes, Budget Deficits, Traditional and Ricardian Traditional Ricardian Views of Government Debt, Fiscal Stimulus, Social Security Topic 12 (Text: 15.1-15.3; Pres Topics #6, 7 & 8) 1 Overview • Government continuously enacts rules and laws that have revenue and tax implications for private firms • We think of these as incentive-related incentivepolicies, and they have mainly microeconomic implications microeconomic We won’t deal with those types of policies, won’ even though they may be very important 6 Fiscal Policy • The government’s broad policies on government’ expenditures, taxes, and therefore its borrowing is called fiscal policy • Current example: The “bailouts” bailouts” 7 Taxes Corp. Income Excise and customs Social Security & Medicare Individual Income Federal Government Gov Purchases: Goods, Services, Labor Interest Transfers: Social Security, Welfare, Medical, States 8 Taxes • The Federal government’s revenues come government’ from: Individual income tax including interest, dividend & capital gains taxes including Corporate profit tax Excise and customs, and Social insurance levies SS & medicare The fiction of separateness 9 Taxes (cnt.) cnt.) • The State governments’ revenues come governments’ from: Individual income tax Corporate profits tax Property tax Sales tax Social insurance levies, and Federal aid 10 Taxes (cnt.) cnt.) • Two types of taxes: 1. Lump-sum taxes: The same amount of tax is Lumpamount of levied irrespective of income (or whatever criterion is used for taxation) These taxes do not skew incentives -- no matter what you do, you are taxed the same; i.e. they are non-distortionary non Except for fee-type taxes (some excise taxes) feeimpractical and politically infeasible One possible example is SS taxes (income cap) 11 11 Taxes (cnt.) cnt.) • Two types of taxes: 2. Proportional taxes: Tax depends on the amount or size of the activity e.g., certain fraction of income is taken by the government in income taxes practical to implement, but alter the behavior of individuals and firms therefore they are distortionary taxes distortionary 12 Government Expenditures • Economists don’t have a lot to say about don’ the appropriate amount of government amount expenditures Creation of public goods Outcome of the political process and the country’s country’ circumstances Defense, regulation, internal security (police, fire fighters, homeland security), legal system, funding of basic R&D, and many others Transfers Also outcome of the political process Some have the character of a public good 16 Government Expenditures Again • Economists tend to analyze the incentive structures of the political process whether there is over or underproduction of public goods • Economists also analyze the “hidden costs” costs” of financing government expenditures Distortionary taxes All proportional taxes create distortions, i.e., inefficiencies Unacknowledged future costs SS is the best example • Hence the emphasis on gov. financing gov. 17 17 Increases in Gov Expenditures In Full Employment • G means expenditures in goods & services, goods does not include transfers • If government uses more resources the private sector has to use fewer resources Private C, I, S will have to go down This does not mean that people are worse off, does if the increase in expenditures provide for if desirable public goods! It does mean that it is not a good way to does increase GDP or its growth rate GDP 18 Increases in Gov Expenditures In Recession & Unemployment • Increased government demand may stimulate output and employment, because idle resources may be put to work At best a transient short-term fix shortThis kind of increase in GDP does not mean GDP that people are necessarily better off! Goes back to the short-term neutrality shortdiscussion Temporary reductions in output and employment may be optimal Fiscal policy is a blunt and broad weapon! 19 “Multipliers” • A term that has come back into use with the current situation • If you spend $1 government, by how much does GDP go up? It depends on the economics situation and where and how firmly you fit in the conviction spectrum 20 “Multipliers” • At “full employment” mult = 0 or mult < 0! • If you spend the $1 in transfers the multiplier ought to be less than if you spend it directly • Barro in a recent article claims that over WWII, the government spending multiplier was 0.82 • A lot of the discussion before passing Obama’s relief package was about multipliers Different assumptions give different answers 21 Budget Debt and Deficits • Governments all over the world borrow to finance a shortfall of revenue compared to expenses; some of reasons: Don’t have to raise taxes now Don’ Taxpayers can postpone payment Finance capital projects Finance large transient expenditures Unable to collect taxes • They borrow in their own currency and they borrow in foreign currency 22 Budget Debt and Deficits • Question: Are deficits a good thing? Should we worry? • Deficit financing is one of the three BIG issues in fiscal policy • The Others? Social Security, Medicare/Aid Social Is SS going bankrupt? Do we have to change the system? Can we sustain Medicare/Aid? 23 23 Budget Deficits • Government outlays (spending): Government purchases (G) Transfer payments (TR), and Net interest payments (INT) • The budget deficit is then defined as: deficit = outlays - tax revenues Deficit = (G + TR + INT) - T TR INT • Primary deficit excludes net interest from government outlays = (G + TR) - T TR 24 Example #1 • Let Gov. purchases SS payments Welfare payments Interest on Debt Income taxes Corp taxes SS & Medicare levies = 300 = 200 = 100 = 30 = 220 = 40 = 140 • What are government spending and receipts? Gov Spending = Gov Receipts = 25 Example #1 • Let Gov. purchases SS payments Welfare payments Interest on Debt Income taxes Corp taxes SS & Medicare levies = 300 = 200 = 100 = 30 = 220 = 40 = 140 • What are the budget deficit and the primary deficit? Def = Def(Prim) = Def(Prim) 28 28 Example #1 gov. purchases gov. SS payments Welfare payments Interest on Debt Income taxes Corp taxes SS & Medicare levies = 300 = 200 = 100 = 30 = 220 = 40 = 140 • What are the government transfers? TR = TR 31 Actual & Projected Deficits Actual and Projected Federal Deficits 4.0% 2.0% -0 8 -0 6 ar M -0 4 ar ar M M -0 0 -0 2 -9 8 ar ar M ar M M -9 4 -9 6 -9 2 ar ar M M -9 0 ar M ar M M ar -8 8 -8 6 -8 4 ar ar M -8 0 -8 2 M ar ar M -7 6 ar -7 4 ar ar -7 8 M M M ar -7 2 M M M ar -7 0 0.0% -2.0% -4.0% -6.0% -8.0% FED DEFICIT CBO PROJECTED -10.0% 34 Debt • The accumulated budget deficit is the accumulated national debt. Deficit is a flow, debt is a stock Not all government borrowing shows up in the “unified” budget unified” Differences between state & Fed budget processes • A useful measure is the Debt-GDP ratio Debt From the 1980s until recently, federal government spending far outstripped revenue, causing the debt to double from its 1980 level and the Debt-GDP ratio to climb DebtDoes it matter? 35 35 Debt (cnt.) cnt.) • Dynamics of debt Dt+1 – Dt = Deft Def Dt+1 – Dt = Primary Deficitt + it-1 Dt Primary where it = nominal interest rate Deficits add to the government’s debt government’ • The Debt/GDP ratio is a reasonable measure Debt of the impact of debt 36 How Indebted Are the World’s Governments? Country Debt to GDP ratio in 1998 Belgium 125% Italy 123 Greece 103 Canada 94 Japan 93 Sweden 76 Spain 74 Netherlands 73 Austria 73 Ireland 67 Denmark 67 Germany 66 Portugal 65 France 65 United States 65 United Kingdom 60 Source: Mankiw 2000 37 The Debate on Budget Deficits • Government levies taxes to finance its spending It can levy taxes equal to G1 T1 = G1 It can tax T1 < G1 (current scenario) and borrow borrow (G1 - T1) to finance spending; i.e. run a deficit and sell debt • Is this “good” or “bad” for the economy? good” bad” Current generations? Future generations? 39 39 The Traditional View of Deficits Traditional view: • A tax cut of $1 disposable income by $1 part is consumed and the rest saved Spvt by < $1, while deficit Sgov by $1 As a result, Spriv + Sgov (total saving), S, Equilibrium real interest rate Investment 40 The Traditional View (cnt.) cnt.) • With persistent deficits, accumulation of domestic capital slows down future generations will experience a lower standard of living Solow model predicts a lower steady state level of capital and per capita income when the saving rate decreases 41 The Traditional View (cnt.) cnt.) • According to the traditional view, the reduction in the future standard of living is the true burden of government debt • The argument crucially depends on how consumers behave in response to such a tax cut (through Spvt) • “If some of the debt is held by foreigners, then the future generations will also have to pay interest to them.” them.” This is true but irrelevant, as long as the debt is in home currency 42 42 The Traditional View (cnt.) cnt.) • Notice that the issue is NOT: how will our NOT children pay all this back? What it is about paying back the debt? Is it optimal to ever do that? ever 43 Example #2 (Traditional View) • Suppose private consumption is given by C = C0 + (Y – T) ; = 0.60 (Keynesian consumption function) C0 = 100, Y = 2,000, T = 600, G = 600 600, 600 What is Current Consumption, Priv. Saving, Current Priv. Nat’l Savings? Nat’ C SPriv SNatl 44 Example #2 (Traditional View) • Gov. decreases taxes to 400 without decreasing spending C = C0 + (Y – T) ; = 0.60 C0 = 100, Y = 2,000, T = 400, G = 600 400, 600 What is Consumption, Priv. Sav, Nat’l Sav? ’ Consumption Priv. Nat C = SPriv = SNatl = 48 48 Brief Review • Deficit = (G + TR + INT) - T TR INT Debt/GDP is the usual way we compare deficits over time and across countries • What is the traditional “burden of the debt”? debt” Lower std of living; not the interest payments not • The “thought experiment” is: experiment” Gov cuts taxes while holding spending the same Bush policy (also the old Reagan policy) Does this change private behavior? “Traditional View” YES! Reduces Nat’l View” Nat’ Savings, k, and therefore steady state y 51 The Ricardian View of Deficits • Ricardian view: postulates a forwardforwardlooking consumer and examines if a tax cut will consumption Simple logic of government’s budget constraint: government’ PV(Gov Spending) = PV(Tax Revenue) Otherwise no one would lend to government Current deficits (& therefore lower taxes) lower imply future higher taxes higher Conclusion: the “tax cut” is not a tax cut in PV cut” in 53 The Ricardian View of Deficits The Ricardian conclusion is that consumers will save all such tax cuts, and national savings will save national not change Private savings will offset the government deficit We’ll show this in a simple model We’ • Assume government cuts taxes and runs a deficit, while holding current and future while government expenditures fixed Taxes are lump-sum lump- 54 54 The Ricardian View of Deficits • The budget constraint for a consumer in the 2-period model is (discussed in T.6) PV(consumption) = PV(net income) (consumption) PV C1 C2 Y T Y1 2 T1 2 1 r 1 r 1 r Recall that the PV of a series of cash receipts over PV time is: PV X 0 , X 1 , X 2 , X 3 X 0 X1 X2 X3 1 r 1 r 2 1 r 3 55 Ricardian View (cnt.) cnt.) • The government’s government’ constraint, is: intertemporal budget PV (Gov. Expenditures) = PV (Taxes) PV PV G G1 G2 T T1 2 PV T 1 r 1 R 56 Ricardian View (cnt.) cnt.) • If planned government expenditures do not change (Fix G1 and G2 ) change Government decreases taxes by T today and finances this tax cut by borrowing, In the next period it needs to increase taxes by (1+r) (1+ T, to repay the debt and the accumulated interest PV G T1 T T2 T 1 r PV T 1 r 57 57 Ricardian View (cnt.) cnt.) • What happens to the consumer’s budget constraint? consumer’ She gets a tax break of T, so her first period income is T She knows that the government has to go out and borrow T to finance its expenses She also foresees that the government will have to repay its debt debt and it will have to increase her taxes by (1 + r) T to finance repayments (1 nd period after tax income to be She expects her 2 (1 + r) T T 1 r 0 The PV of this = 0! T 1 r • The net effect is to leave the present value of her income, and therefore her consumption plan, unchanged unchanged 58 Ricardian View (cnt.) cnt.) • The key is: Consumers care about the Present Value of their Present tax obligations Straight from the Permanent Income idea Government’s reducing taxes now and having to Government’ increase them later doesn’t change the PV of taxes doesn’ PV It is a shell game Therefore, the consumer is neither better or worse off Doesn’t change her consumption plan! Doesn’ The tax cut becomes additional saving It’ll be used to pay the future higher taxes It’ 59 Ricardian View (cnt.) cnt.) • In algebraic terms Consumer’s budget constraint with this tax cut: Consumer’ Y2 T 1 r T T1 T 2 1 r 1 r Y2 G 2 Y1 G1 1 r PV Y1 60 60 Ricardian View (cnt.) cnt.) • Implication: A balanced budget every year is not necessarily good. For instance, during a war instead of raising taxes on an already overburdened public, it might be welfare improving to run a deficit; it does not SNat’l Nat’ this is because taxes have distortionary costs distortions increase exponentially with taxes 62 Government Cuts Taxes by $1 by $1 and Borrows $1 SNatl Traditional View View Spriv Sgov by < $1 by < $1 by $1 by $1 by $1 Ricardian Unchanged View 63 63 Example #3 (Ricardian View) (Ricardian • Suppose private consumption is given by C 1 PV Net Inc 2 Y1 = 1,600, Y2 = 1,100, T1 = 600, T2 = 660, 600, G1 = 600, G2 = 660 (balanced budget each period), r = 10% 600, 660 64 64 Example #3 (Ricardian View) (Ricardian • Suppose private consumption is given by C 1 PV Net Inc 2 Y1 = 1,600, Y2 = 1,100, T1 = 600, T2 = 660, 600, G1 = 600, G2 = 660 (balanced budget each period), r = 10% 600, 660 What is Perm. Inc., and the PVs of G, T? Perm. G, Perm Inc = PV(G) = PV PV(T) = 65 Example #3 (Ricardian View) (Ricardian C 1 PV Net Inc 2 Y1 = 1,600, Y2 = 1,100, T1 = 600, T2 = 660, 600, G1 = 600, G2 = 660, r = 10% 600, 660, What is Current Consumption, Priv. Saving, Current Priv. Nat’l Savings? Nat’ C = SPriv = SNatl = 67 Example #3 (Ricardian View) (Ricardian • Government reduces current taxes by 200 without changing expenditures. What happens to Current Current Consumption, Priv. Saving, Nat’l Savings? Priv. Nat’ Y1 = 1,600, Y2 = 1,100, T1 = 400, G1 = 600, G2 = 660, 600, r = 10% C SPriv SNatl = = = 69 69 Empirical Evidence for the U.S. Federal Deficits & the Real Rate 10.0% FED DEFICIT 10Y Real Rate CAB/GDP 8.0% 6.0% 4.0% 2.0% -0 8 -0 6 ar ar M -0 2 -0 4 ar M M -0 0 ar M -9 8 ar -9 6 ar M M -9 4 ar M -9 2 -9 0 ar ar M M -8 8 ar M -8 6 ar -8 4 -8 2 ar ar M M M -8 0 -7 8 ar -7 6 ar ar M M M -7 4 ar M ar ar M M M ar -7 2 -7 0 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% 73 The “Burden” of Debt in a Nutshell Burden” • Gov takes resources from the economy now now but borrows to pay for them! If this tricks consumers into thinking their tricks income is high, they will save less and k will grow more slowly equilibrium k will be lower The issue is the empirical relevance of Ricardian empirical equivalence 74 The “Burden” of Debt (Concl.) Concl.) Burden” Even if the world is Ricardian • Higher future taxes mean higher future tax distortions Increases the distortionary wedge between wages paid and wages received Distortions increase non-linearly with taxes nonWage elasticity of labor supply is substantial Lump-sum taxes are infeasible Lump- 75 75 The “Laffer” Curve! Laffer” Gov Revenue Tax Rate 76 Do We Have to Pay Back the Debt or Not? • In the 2-period model, government definitely has to pay back the debt • In the real world, mortal entities (consumers) also definitely have to pay back their debt Exceptions are bankruptcies • Entities with indefinite lives have different rules Corporations, governments 77 Do We Have to Pay Back the Debt or Not? • Indefinitely-lived entities have to “show” evidence to the markets that they can pay back their debt Corporations by being solvent Governments through their taxing capacity orderly and lawful society sustainable borrowing • When these criteria are not met, there is a crisis 78 Do We Have to Pay Back the Debt or Not? • What is “sustainable borrowing” for a government? • That debt doesn’t “grow too fast” relative to the economy Basically it means that Debt/GDP cannot be expected to rise indefinitely Short-term rises are OK, as long as the market expects them to stop Stopping Debt/GDP ↑ doesn’t mean running surpluses (paying back the debt) It means growing the deficits at less than GDP growth 79 Fiscal Stimulus • Passive countercyclical fiscal policy Gov revenues automatically fall in a recession Rise in a recovery That means deficits rise in a recession What to do? NOTHING! NOTHING In the past, governments worried about the rising deficits and proceeded to raise taxes In a recession! Nixon 1972, Roosevelt in 1936, Japan in the 1990s 82 Fiscal Stimulus • Active countercyclical fiscal policy Temporary tax cuts in recessions and/or tax and/or increases in government spending government to stimulate consumption spending See: “market failure or optimal response?” response?” Also Tax cut may be saved (Ricardian view) no in C (Ricardian Particularly if it a temporary tax cut temporary Huge lags between need for policy and enactment enactment of policy and effect on the economy Even for “shovel-ready” projects as we are finding out shovel- ready” 83 83 Fiscal Stimulus (concl.) concl.) • Increase government expenditures on goods and services, G, to spend on infrastructure, create jobs, etc. Increase in G on a permanent basis reduces goods and services available to the private sector There is a tradeoff (public vs. private goods) Since Keynesians believe deficits are bad, they would increase taxes to make up for G Problems: Distortionary income taxes decrease labor supply! Distortionary taxes decrease capital formation 84 “Good” Fiscal Policy Good” • Choose an “optimal” level of G and TR optimal” TR Cost-benefit, political equilibrium Cost- • Steady tax rates Lowest marginal rates possible Avoid double taxation Profit taxes? Finance deficit fluctuations • In a growing economy, keep Debt/GDP Debt constant on average This implied a steady-state deficit steady~$14T GDP, $10T debt ~71% ratio GDP 5.0% $growth implies $ ~500B steady-state deficit! steady85 Example #4 Problem #5 at chapter end –Taxes Distort • Workers value their leisure at 90 units of goods. The production function is Y = 250L – 0.5L2. MPL = 250 - L MPL 1. No taxes: What are the equilibrium wage, L, & Y ? wage 91 91 Example #4 Problem #5 at chapter end –Taxes Distort Problem • Workers value their leisure at 90 units of goods. The production function is Y = 250L – 0.5L2. MPL = 250 - L MPL 1. No taxes: What are the equilibrium wage, L, & Y ? wage In equilibrium, workers will give up 1 unit (hour, day) of leisure for 90 units of goods. This, then will be the wage rate! Therefore, w= Y= 92 Example #4 Problem #5 at chapter end –Taxes Distort Problem • Workers value their leisure at 90 units of goods. The production function is Y = 250L – 0.5L2. MPL = 250 - L MPL 2. Wage tax 25%: What are the equilibrium wage, L, & 25%: wage Y ? What is the distortion cost of the tax in terms of output? w= Y= 94 Glossary G Government expenditure S C National Saving = Spvt (private saving) + Sgov (govt. saving) Consumption of households T T r Y PV(X) Perm.Inc. Perm.Inc. Taxes (T1, T2, in two-period setup) twoChange in taxes Real interest rate Real income (GDP) Present Value of X Permanent Income (G1, G2, in a 2-period setup) 2- (C1, C2, in 2-period setup) 2- 96 96 THE END 97 ...
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This note was uploaded on 03/02/2010 for the course BUAD 350 taught by Professor Safarzadeh during the Spring '07 term at USC.

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